http://www.indexuniverse.com/sections/features/19816-ferri-vs-arnott-is-smart-beta-real.html?showall=&fullart=1&start=2Ferri's thesis (which I agree with) is that "fundamental indexing", and now "smart beta" are marketing terms designed to confuse investors. That what is called "fundamental indexing" are just quant funds.
I tend to go a little further; using the new marketing term, I might call these funds "stupid beta". Unlike quant funds that advertise themselves as such, these fundamental indexes are more static - not in the holdings, but in the factors and weights used. That may leave them prone to failing more quickly that quant funds (which, empirically do seem to fail after several years despite tweaks). Thus, "stupid beta".
Wish I had more data to back up these impressions. So take them for what they're worth. The article does articulate the terminology/marketing issues with these funds.
Comments
FUNDAMENTAL indexing is better because back-testing results, Arnott could show it worked better than traditional indexing. The more people he sold on it, the more idea was successful.
Results - ALL in the past - are used by marketing to their benefit. It has nothing to do with how sound the idea is or its predictive power. IMHO it is pointless to discuss whether Fundamental indexing is better than not. I believe ETFs are the next big scandal to happen, but right now ETF marketeers are taking share away from mutual funds.
Marketing - bane of capitalism. License to bullshit. Let's deal with it.
What people don't seem to get about the statement is that (a) it is an average, (b) one must be talking about the same market - the same pool of candidate securities (e.g. total US stock market, all bonds rated BBB or better with maturities under 10 years, etc.), and (c) one must be looking at all costs including commissions, market impact, management and distribution fees.
So it is not all in the past, until one starts talking about "indexing" which doesn't follow these simple arithmetic rules.
I absolutely agree with your astute observations.
Smart Beta is more about smart marketing than about smart investing. It is not Indexing in its traditional format, but rather various forms of active fund management strategies.
From my perspective, that’s very acceptable as long as it is clearly advertised and recognized as such. The S&P 500 Index is not the entire US equity marketplace; it does represent roughly 80 % of that market. Conventional Beta measures relative holding sensitivity to overall equity market movement using the S&P 500 as a proxy standard.
Fama and French uncovered both Value and Small Size benefits that can be realized by an increased portfolio weighting in these special market segments. The research suggests that perhaps a 2 % incremental increase in annual returns can be captured by expanding from the Bill Sharpe single factor Beta model to the three factor Fama-French model.
Many of the newly minted Smart Beta offerings deploy strategies that emphasize smaller, value oriented holdings. Some studies by the London-based Cass business school confirmed that many expanded factor models can outperform the simple single factor formulation.
This is really nothing new. We’ve been aware of the Fama-French findings for decades and, as an informed individual investor group, have exploited that knowledge by including smaller, value-oriented units in our portfolio construction. The Smart Beta funds are just doing that task for us and are, of course, extracting a fee for the service.
As John Bogle famously said: “The more the managers take, the less the investors make”.
The markets are controlled by a strong pull of the “regression-to-the-mean” attraction. Also, just like in physics where there are fundamental conservation of mass, energy, and momentum laws, it appears that the marketplace is governed by a conservation of profits law.
If someone makes excess returns, someone else must surrender equal amounts of negative excess returns to balance the conservation law. When integrated over all investors, this global investor universe must make equity market rewards on average minus costs.
Indeed, for short periods some lucky Smart Beta operator will generate excess returns. But the scale will be balanced by a Dumb Beta operator who will momentarily not make his benchmark. Who will win and who will lose? I surely do not know.
You are now playing the active fund management game once again. There will be years of excess profits, but there will also be years of undersized rewards. The fund fees and the more hidden trading costs will remain constant however through both good years and bad years.
I probably can make a safe forecast that today’s winners are likely to be tomorrow’s underperformers. All the various Periodic Tables of category annual returns clearly illustrate the rapid ascent and descent on these categories on an annual basis. Persistent performance is non-existent. The ubiquitous “regression-to-the-mean” strikes again.
These newer investment products get exposed to the acid test each and every year. The performance data has been accumulating for a decade or so at this juncture. This data will demonstrate their efficacy or their shortcomings. It is a daunting challenge since some of these products have already disappeared from the marketplace, but are being amply replaced with a never ending supply of inventive and innovative alternatives.
One thing is certain, Wall Street will get its cut of the pie. Remember that the size of the pie does not increase with the addition of these products. Only real businesses, not day trading, grow the economic pie. Therefore, if Wall Street takes a larger piece, the global investors as a whole must accept a smaller fraction.
Taking all investors as a global group, that’s not good since the Wall Street gang extracts a larger amount of the fixed annual market returns.
Best Regards.