Smart Beta needs to come out of the closet

By Dan Hallett, CFA, CFP on February 9th, 2014

With the 2000s’ ballooning list of indexing products I was compelled to give indexing hopefuls a dose of straight talk nearly five years ago.  My message then:  To fully capture indexing’s long-term benefits investors should simply focus on obtaining the broadest exposure possible at the lowest available cost.  I doubt that index investors have since embraced that advice, evidenced by the successful launch of so many exchange traded funds that hold small slices of the market, rather than the whole thing.  One such group of products known as ‘Smart Beta’ would be more accurately labelled ‘Closet Alpha’.

The ETF industry has created the Smart Beta label to describe rules-based investment strategies that aren’t focused on tracking a traditional market benchmark.  For example, instead of passively following the S&P/TSX Composite Index – the broadest measure of the Canadian stock market – investors can find ETFs that use a strategy to buy only those TSX stocks that pay a dividend, or shares of smaller companies, or stocks have lower valuations or strong price momentum.  The list goes on.

The Smart Beta label is clever because the branding keeps such products closely tied to ETFs’ and indexing’s core philosophy of tracking a particular group of stocks (i.e. beta exposure).  The name also conveys the message that such strategies are smarter investment strategies.  Some suggest that Smart Beta blurs the line between active and passive management.  But it’s clear to me that Smart Beta is simply active management in disguise.  So for the rest of this article, I will use the term Closet Alpha as synonymous with Smart Beta.

All Closet Alpha strategies implicitly assume that market-cap benchmarks – which weight stocks by the market value of their shares – are inherently flawed.  Closet Alpha strategies represent alternative ways of selecting or weighting stocks in an effort to improve upon traditional “market cap” benchmarks.  Similarly, active managers argue that indexes are sometimes too concentrated and overweight over-priced stocks – the same arguments used by virtually all of the architects of Closet Alpha strategies.

Taking the stocks in an index and weighting them each equally (rather than by market cap) indirectly gives smaller companies greater prominence.  The popular Fundamental Indexing strategy, many have argued, is simply a way to overweight cheaper stocks.  The superior performance of “value stocks” has been reported by practitioners and academics for several decades, most notably by Benjamin Graham in 1976 interview when he stated his preference for simple computer screens over elaborate and exhaustive research methods.  (As an aside, fundamental indexing creators Research Affiliates did a study on different strategies, including ‘upside down’ strategies.)

In my view, if a strategy is designed to select or weight stocks by any factor other than market cap it is active management because the strategy is designed to invest more smartly than the market cap benchmark.  As a proponent of smart and efficient active management, I have no problem with this concept and I like a few of these strategies.  I take issue, however, with trying to dress it up as something it’s not – pure beta exposure or indexing.  So come out of the closet Smart Beta and better inform investors and advisors by embracing your active management.

See also:  The active passive investor (May 2013)