The Promise of Smart Beta by Research Affiliates
In the latest piece from Research Affiliates, Jason Hsu, Co-Founder and Vice Chairman of Research Affiliates, provides his commitment and reasserts that of Research Affiliates to deliver on the promise of smart beta. Forty years ago, Jack Bogle helped revolutionize the industry for the benefit of the investor. Today there is opportunity for a second revolution—promising to bring the same low costs and high transparency to additional equity factors. Can smart beta break free from the conventional objectives of asset gathering and obfuscation, and deliver on that promise?
The Promise of Smart Beta
By the early 1970s, the finance literature had already documented that the average mutual fund consistently underperformed the market index, net of fees. The literature also demonstrated that a diversified “market” portfolio would naturally earn a positive equity risk premium without the help of a skilled stock picker. Armed with these academic findings, Paul Samuelson (1974, p. 18) challenged investment practitioners to consider creating investment portfolios that track the S&P 500 Index.
Samuelson’s short article struck Jack Bogle (2014, p. 42) “like a bolt of lightning.” Recounting the early history of Vanguard, Bogle identifies Samuelson’s challenge as a major impetus for the creation of the first index mutual fund. Vanguard’s low cost index funds, to me, were born out of a deep awareness of the academic literature and a deeper concern for the welfare of the end-investor. Nothing in our industry has so inspired me.
As a champion of smart beta and a spokesperson for Research Affiliates, which regularly debates Vanguard on the definitions of “beta” and “index,” I am unlikely to be confused for a “Boglehead.” However, I have the highest respect for Jack Bogle’s contributions. In fact, I would love to see the smart beta revolution yield the next wave of low cost investment solutions firmly grounded in academic research and the investor-centric philosophy he championed. However, we’re a long ways off from there at the moment and I’m concerned. Let me explain.
It is no secret that investment management firms are profit-seeking organizations relentlessly competing for more assets. Even small investors who are unsure of the difference between active and passive managers know that both are trying to make a living. So, for the record, let’s say it loud and clear: Investment management is a for-profit enterprise. As such, asset managers and asset owners have a relationship beset with natural conflicts.
Asset owners want fees below 10 bps; asset managers prefer “2% + 20%.”1 Asset owners want transparency; asset managers favor black-box opacity. Asset owners want simplicity; asset managers hire rocket scientists to create complex optimized solutions for sex appeal.2 Asset owners want “future” outperformance after they fund a manager; asset managers would be satisfied with strong past outperformance to facilitate future asset gathering. Asset owners want a bigger alpha; asset managers would happily sell them the possibility of alpha and charge handsomely for the service of selling hope.
So, how does all of this relate to smart beta? Currently, asset managers are arguing heatedly about the right definition for smart beta. Some of our fellow investment managers secretly, and some publicly, hate the smart beta moniker. It’s not the “smart” that annoys them. We all think we are plenty smarter than the market. We simply wish it were called “smart alpha.” If normal alpha could fetch “two and twenty,” imagine what one could charge for smart alpha!
Online at: “The Promise of Smart Beta”
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