“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.”

 

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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Comments

  1. Smart beta is just another way of trying to trick stupid people into making stupid portfolio decisions.

  2. The irony here is that Malkiel is trying to get rich selling an idea that’s similar to what he criticizes a lot of Wall Street for doing. If he were true to his word he’d tell people to buy a two fund aggregate index and call it a day. Instead, he’s come up with this elaborate marketing scheme to sell to people. There’s so much hypocrisy in all of this that it makes me want to barf.

  3. There’s no getting away from the simple reality that if you use index funds in a passive long only approach then you end up with a portfolio that is going to be very highly correlated to the aggregates you’re using. It seems that many of these index fund companies are simply trying to come up with better ways to trap the mice using what’s nothing more than different versions of the same trap.

  4. Yeah. It’s funny to see Vanguard having cornered the market here as everyone else tries to scramble to prove they’re doing something that’s better and worthy of higher fees.

  5. Here’s my general view. Basically, we’re all active investors and the important thing to understand is that different levels of activity and different approaches have different positives and negatives. But the entire concept of “passive” vs “active” is a marketing tool designed by people who wanted to differentiate their views from someone else’s.

    http://pragcap.com/were-all-active-investors

  6. Malkiel and Vanguard are equal hypocrites – passive investing is an equally overblown myth with a) some good luck of having had the 1980-2000 bull market; and b) some equally clever marketing, including academic.

    The same can be said for “risk parity”, “target date funds”, etc …

    No turnkey investment strategy is smart, but the marketing is.

  7. Exactly. If Malkiel’s firm just sold just various allocations of VT and BND then people would figure out there’s no need for them and that their Vanguard account does the same exact thing.

  8. Isn’t it possible that the “best” balance of index fund in a portfolio is dependent on both age and ability to tolerate volatility (i.e. losses). I don’t know if Wealthfront claims to take these issues into account, but the optimal portfolio isn’t the same for every investor.

  9. If you were a true passive indexing purist you’d take the aggregate bond index and the aggregate stock index and weight it according to your risk tolerance using something like the efficient frontier.

    Whether or not that actually makes sense for most investors is highly contestable, but probably better than most of your other options given taxes, fees and other frictions.

  10. I’ve done a bit of research into this WealthFront concept. It’s basically an automated index fund approach that claims to add to your returns by being able to better manage your index funds for you than an aggregate index can.

    I have no idea how this isn’t a total contradiction of everything Malkiel stands for. And I have no idea why anyone would pay 0.25% on top of the 0.1% index fund fee for such a service.

  11. Vanguard administers a substantial employer sponsored retirement plan with which I am familiar. No one else came close to matching Vanguard on expenses (we comparatively priced it and teased out the hidden costs) and their fund selection is surprisingly robust. Vanguard delivers exactly what it promises. It’s great for Mom and Pop, but for higher octane fun and games you go elsewhere.

  12. Everybody wants to find that magical asset mix.
    There are a lot of strategies out there that try to expand the traditional 60 stock/40 bond mix. Managers are trying to sell all kinds of alternatives like commodities, gold and silver, emerging market debt, etc., and alternative strategies like various levered and hedging maneuvers.

  13. I don’t know if I agree with this general dismissal of smart beta. I for one think that a lot of the strategic planning at AQR is innovative and a positive contribution to portfolio construction. I agree that taking a simple index and changing small parts of it to give the appearance of increased alpha generation can be misleading, but there are degrees of smart beta and I think it’s unfair to generalize about it.

  14. This topic is not so black and white. Morningstar had a good article on the topic and I much prefer their terminology: “strategic beta.” There are lots of different factors that can be applied and so talking about strategic beta strategies is like talking about “bonds.” There’s a HUGE variety and painting with an over-broad brush is a disservice.

    Morningstar also makes the point that strategic beta strategies fall in the intersection of active and passive (via a Venn diagram illustration).

    I have the hard copy so I’m not sure if the report is available online for free viewing or not.

  15. I think some of the confusion probably comes from the fact that Smart Beta isn’t really defined very well. My understanding is that Smart Beta is the reweighting of an index to capture alpha. It is supposed to be smart indexing. So, you use an index weighted by revenues or you use an index weighted by equal weight or you create an index as WealthFront has by picking certain types of index components.

  16. I would be hesitant to intermingle all strategic styles under the umbrella of “smart beta”. Smart beta is just a different form of weighting an index via some alternative set of rules. The key is that you’re just designing a smarter index (or, supposedly smarter) and adhering to what’s traditionally thought of as “passive” investing. Tactical asset allocation and many other strategic styles fall outside of this form of portfolio management.

  17. Smart Beta is no longer about a different weighting scheme. Second generation Smart Beta indices is trying to prudently structure the different beta exposures with a view to turnover.

    These new index methodologies has intelligence built into both selection, weighting and rebalance algorithms.

    Dont forget Cap-Weighted indices while cheap has a large-cap and Momentum bias, and typically carry a Country and Sector tilt.

    I think we are in a interesting phase now, because on one hand we have this expanding crop of advisors who are successfully building a business on utilizing low-cost index based ETF mainly using Passive Cap-Weighted ETFs, simply because they are cheapest.

    These mainly Passive Index based Advisors OUTPERFORM traditional advisors Active portfolios, because the active component has not been able to cover the embedded cost associated with it.

    On the other hand we have a shift in the understanding on how a portfolios is prudently structured..

    A Risk & Performance efficient portfolio need to be diversified not only across Assets, but also across Strategies.

    New portfolio construction techniques are based on framework, whereby a Core Liability Hedging Portfolio is constructed uniquely for each client, and the allocation between this and the traditional Risk & Performance seeking Satellite portfolio, is a function of a dynamic risk budget.

    RoboAdvisors do not utilize such framework and could probably not do this at a fee of 30bps, since it requires an element of human involvement. Im not sure Traditional HNWI or UHNWI Advisors use it either, as the diffusion of knowledge is very slow in the domain.

    So to conclude I believe that while the RoboAdvisors has growing traction, I believe there is a potential problem waiting here, as the allocation models are still poorly structured.

  18. Think Smart beta is not as un-smart as it is made out to be. By whatever name you call it but investing in a basket of stocks, where stock selection is based on a theme/strategy ( Cap weighted is one of them ) is valuable and in many cases is superior to the cap weighted index. For e.g., in India the popular NIFTY Index is Cap weighted index – we have many family owned conglomerates and its not uncommon to find 4/5 stocks from the same group in the 50 stock index , such selection completely throws out the diversification. In my view there is certainly a case for alternative weighting or stock selection than plain cap weighted. Other subtle point is that Cap weighted is both a strategy and weighting function where as Equal weighted is just an weighting function. A smart beta index could be one created on the principle of Risk Parity for example and it is quite possible that a risk parity index returns is more suitable for a risk averse investor than the traditional index return.