When ‘smart beta’ investing can be dumb! Financial innovator and thought leader, Research Affiliates’ Robert Arnott warns about pitfalls with the popular strategy he helped create.
Another day, another stock market rally, and yes, more records being set. The Dow Industrials, the S&P 500 and the Nasdaq Composite all finished at new peaks.
Since the November 8th presidential election, the bull market has accelerated, adding to the rationale that passive index investing is a better choice than investing with traditional active managers.
Since 2009, passively managed funds, based on market indexes like the S&P 500, have exploded, from 11% of global assets under management to 19% last year, a 73% gain, with no slowdown in sight.
Investors are switching for two reasons. The most important being that market based index funds have been outperforming the vast majority of actively managed funds for the last decade.
According to the investment classic, Winning The Loser’s Game: Timeless Strategies For Successful Investing” by financial thought leader and frequent WEALTHTRACK guest, Charles Ellis:
“In round numbers, over one year, 70 percent of mutual funds under perform their chosen benchmarks. Over 10 years, 80 percent under perform.”
The other major reason: index fund fees are much lower than actively managed ones, and they are falling rapidly. Many of them now charge just 0.05%, or 5/100ths of a percent!
This week’s guest has been critical of traditional index funds because they are based on what’s known as market capitalization weighted indexes, which means the index is dominated by the companies with the largest stock market value. The top 10 companies by market weight in the S&P 500 for instance account for nearly 20% of the index. They include three of the so called FANG stocks: Facebook, Amazon and Google parent Alphabet, as well as blue chip giants like Microsoft, Exxon Mobil and Johnson & Johnson.
Critics of these traditional market cap weighted indexes say that’s the problem. Investors end up owning the most expensive stocks, whereas smaller companies, or those not appreciating as much, or declining more, have much less of a share.
This week’s guest is Robert Arnott, Chairman and CEO of Research Affiliates, which he founded in 2002 as a self-described “research intensive asset management firm that focuses on innovative products.” Among the innovations that he has pioneered is what he calls fundamental indexation, building indexes with stocks based on the size of their fundamentals, such as sales, profits, cash flow, book value and dividends -not their stock price.
His firm Research Affiliates has created a series of fundamental indexes for a variety of markets and asset classes around the world. The RAFI Indexes were early entries in an approach to investing that has become extremely popular called smart beta.
Smart beta is an umbrella term for multiple index strategies based on characteristics other than market price. As the Financial Times defines it: “Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices…”
But have they and will they in the future? We will address that question among others in the interview.
In addition, Robert Arnott and his team have recently published a series of research articles on the future of smart beta which he is sharing with us.
If you’d like to see the show before it airs, it is available to our PREMIUM subscribers right now. We also have an EXTRA interview with Arnott exclusively on our website about his unusual hobby of chasing solar eclipses!
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Thanks for watching. Have a great weekend and make the week ahead a profitable and a productive one.
Article by WealthTrack