Richard Ferri Portfolio Solutions doesn’t like “smart beta” and he didn’t hold back in a Morningstar breakout session on the topic.

Smart Beta equal weighting

Richard Ferri doesn’t know what smart beta is

“I don’t know what ‘smart beta’ is,” he said. “It’s a marketing phrase. I would be surprised if 10% of the people running around saying ‘smart beta’ even understand what beta is.” Beta investments, normally associated with market index investments which are typically tied to large market forces such as the S&P 500, are opposed to stock picking or investing using a unique stock selection methodology.

“Smart beta is the flavor of the day,” said Chris Brightman, of Research Affiliates. He addressed various methods of “smart” portfolio rebalancing, such as systematically selling stocks that have over performed in the short term and buying stocks that have underperformed. “This doesn’t work in momentum markets.”

“Smart beta is defined by me as anything that isn’t beta,” Ferri said, as he outlined three disadvantages of investing in “smart beta.”

Beta free of cost

“The cost of beta is free, and anything other than beta is more costly,” Ferri said, noting that the point of beta products is to keep the drag on investor performance through fees at a minimum. Not only is “smart beta” more expensive than traditional beta investment products, but it isn’t as safe. “There is always more risk when get away from beta,” he said. “Any other beta is additional beta, not smart beta.” The third disadvantage is there are long periods of time when these strategies underperform the market, noting that small cap value products under performed for two decades.

“None of these are magic strategies,” Brightman said, considering how many of these “smart beta” strategies have delivered significant performance recently. “There will be uncomfortable periods of under performance for any strategy.

Ferri also noted that for financial advisers in the audience, beta strategies are less risky for an advisor’s own business.  “Is your client (a retail investor) going to stick with an underperforming investment for ten to twenty years? Likely not,” he said.

Evolution of ETFs has given advisors more choices, but now need to do more research, Ferri said. “Nothing fails on Wall Street like success. My fear on all these strategies is they have done well, it has attracted performance chasers.” Now might not be the right timing to invest in the products, he said, citing mean reversion aspect of investing. What is hot one year might not be the following year.