“Smart Beta” & Smart Beta Hypocrisy

Smart beta is the new buzzword on Wall Street.  No one really knows what it is because the term doesn’t have a specific definition, but the easiest way to understand what “smart beta” funds do is that they’re basically tweaking index funds to try to generate some extra return.  For instance, instead of using a market cap weighting you might use an equal weight.  Then these fund managers perform all sorts of backtests, crank out something with a heavy dose of confirmation bias and sell an ETF that’s basically an index fund marketed as something that’s superior than a broad index.

I think Burton Malkiel really nails it here on the WealthFront website when he says:

“Smart Beta” strategies rely on a type of active management. They are high cost and tax inefficient relative to traditional index funds and none have reliably and consistently beaten the market. As recent research and commentary from Vanguard Group puts it “Smart Beta” strategies are often, “active bets and not substitutes for traditional index funds.”

“Smart Beta” portfolios are more a testament to smart marketing rather than smart investing.

That’s basically right.  “Smart beta” is basically marketed as a more efficient form of indexing.  But what’s surprising about Malkiel’s rejection of this is that his new firm, WealthFront, actually does something that’s very similar.  For instance, if you run through the WealthFront portfolio design process for a young, middle income investor with a high risk tolerance you come up with a portfolio that looks like this:

US Stocks: 35%

Foreign Stocks: 24%

Emerging Markets: 18%

Dividend Stocks: 9%

Natural Resources: 5%

Municipal Bonds: 9%

Another way of saying this is:

Stocks: 86%

Commodities: 5%

Bonds: 9%

So what Malkiel is endorsing is actually very similar to what he’s criticizing.  His firm claims that they can pick better or more efficient funds than broad indices.  And then they sell this idea as something “optimal” and back it up with all sorts of vague research that confirms some preconceived bias.  After all, if Malkiel were a true indexer and merely picked the Vanguard Balanced Index or chose three broad funds  like the Vangaurd Total Stock Index, the Vanguard Total Bond Market and the iPath Dow Jones-UBS Commodity Index then my guess is that most of their clients would ask them why the heck they need WealthFront when they can simply open up a discount brokerage account and buy ONE or THREE simple funds?   Of course, that’s where Malkiel will tell you that his firm has chosen “optimal” allocations and enhanced returns through other “active” portfolio management techniques (like tax loss harvesting or “tax aware allocation”).

And this is the problem with trying to define “active” versus “passive” approaches.  The reality is that Malkiel is actually endorsing a strategy that is more active than owning a simple Vanguard Balanced Index or the broadly diversified three fund alternative.  And they’re selling it as something different so they can differentiate their business model and justify charging higher fees than the broad aggregates do.  The reality is that we’re all active to some degree and that the closest thing to a truly passive portfolio is a portfolio that simply buys aggregates rather than pretending to know which funds will generate “optimal” returns INSIDE of specific aggregates.  In other words, as a smart man once said:

“[these] portfolios are more a testament to smart marketing rather than smart investing.”