Smart beta is probably the fastest-growing category in the investment industry. And why not? Who wants to endure another dot-com or housing bust? Who wants mulish indexing when there’s an opportunity to buck the trend?
Yet, doubts remain that smart beta is more than a marketing label. As Wai Lee, CIO and director of research for Neuberger Berman’s quant group points out, in a recent panel on smart beta sponsored by Institutional Investor, Google searches on smart beta far outnumber searches for its main contrast, the classic CAPM theory that suggests buying the market—beta—is optimal. And those Google searches outnumber the underlying dispute with CAPM beta, which is factor-based investing.
Smart beta is simply a form of factor-based investing. Factor-based investing has been around for about 20 years, since the research of Nobelist Eugene Fama and his collaborator, Kenneth French. More recently, MSCI has begun offering indexes based on six different factor-based approaches, not just value and small-cap tilts, but also low volatility and high-quality stock approaches.
Of course, smart beta is not traditional passive investing, says Bob Litterman, executive editor of the Financial Analysts Journal and chair of the risk committee at Kepos Capital, a New York-based investment firm. However, as a rules-based approach, smart beta does lend itself to quantitative strategies. Still, during the financial crisis, quant strategies didn’t work, in part because the space was getting more and more crowded, so excess returns were being arbitraged away. In a rational, CAPM market, that’s how it should be.
Or more concretely, Litterman says, “nothing lasts forever.”
That puts the question squarely: are the factors underlying smart beta persistent? Arbitrage should normalize returns, except that there is still a degree of uncertainty. According to Lee, surveys of smart-beta managers show markedly different portfolio choices, despite approaches that seem to be tapping the same factors.
As Litterman says, there is nothing new under the sun. But not everyone knows that. Yet.