In Defense Of 'Smart Beta'

In Defense Of ‘Smart Beta’

June 9, 2015

by Keith C. Goddard, CFA

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In a recent article, Why Smart Beta is Really Dumb, Michael Edesess encouraged investors to be skeptical of the growing number of factor-based investment strategies being marketed under the moniker of “smart beta.” While I applaud Edesess’ call for skepticism, I am compelled to play the role of public defender and cross-examine his accusations.

To set the stage for this mock trial, I will acknowledge that Edesess, representing the prosecution, has a strong case against my “client.” Furthermore, within the privacy of attorney-client privilege, I am aware that smart beta is guilty of some of the charges against it – particularly the charge of exaggerating its benefits and over-promising future results. Therefore, my strategy for this trial is to seek a plea bargain.

My client will agree to plead guilty to the charge of exaggerating its virtues in return for having all other charges against it dropped.

As the defending attorney, my first objective is to establish my client as an honorable character. The prosecution would like you to believe that smart beta is “all spin with no substance” – a scheme for charging higher fees. This is too harsh. There are numerous smart-beta strategies that offer real solutions for investors at a very reasonable cost.

For example, the defense submits as evidence dividend-weighted indexes. These factor-based strategies deliver efficient access to dividend income from a wide range of geographies and market-cap slices. This innovation is particularly helpful today because central bankers seem to believe that bonds don’t need to offer income to attract investor capital.

The defense submits factor-based indexes for fixed income as evidence of the defendant’s character. These products help investors avoid over-weighting the most heavily indebted companies and/or countries in the fixed-income markets. This frequently occurs with traditional market-cap-weighted indexes.

Please note, for the record, that neither of the examples above depends on a back-test study to define its purpose. Investors can easily understand the value proposition of a dividend-weighted stock index or a factor-based bond index without a slick presentation of back-tested data.

I bring this to the court’s attention because the prosecution has accused my client of data mining without a theory. Indeed, the prosecution included the following quote from economist Fischer Black in the materials for this trial: “Lack of theory is a tipoff: watch out for data mining!”

In response to this charge, the defense hereby submits the theory of Rational Belief Equilibrium. The defense will demonstrate to the court that Rational Belief Equilibrium provides appropriate theoretical support for many of the empirical studies the prosecution claims are only “promiscuous data mining.”

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