Letting the Benchmark Determine the Outcome

The sure thing has become our societal pole star. We have determined to reduce risk as far as possible because the succession of shocks and surprises we have endured over the past couple of decades has challenged our faith in our ability to predict.

From the dotcom bubble to the dotcom crash to the financial crisis(es) and the great recession, nothing seems to work quite as accurately as it used to do.

This upsets us because we are better educated, have more technology and more knowledge than mankind has ever possessed and yet stuff keeps happening to us that Serious People didnt predict. Some of this is hubris, of course: for every claim that no one could have predicted something there are probably a dozen nay-sayers. But some of it may be that our obsession with data has blinded us to the reality that all the information we have accumulated does not necessarily translate into wisdom.

By continually creating benchmarks and yardsticks we gull ourselves into believing we have corralled the life forces that determine the future. The danger - whether it be in investing as the following article explains - or in management and strategy, is that we have forgotten that our very success breeds new, unexpected developments with which we are simply going to have to learn to cope. JL

Paul Sullivan reports in the New York Times:

Once the criteria to screen the holdings have been chosen, the strategy is allowed to run its course.

WHEN it comes to investing money, most people want to be smart about it. So an increasingly popular strategy with smart in its name has intrigued certain investors, while turning off others who see it as little more than a marketing gimmick.

I’m talking about so-called smart beta strategies. Many different strategies fall under this label, but what unites them is their rejection of market capitalization — the value of a company’s publicly traded stock — as a benchmark for creating a passive investment fund. A fund based on the Standard & Poor’s 500-stock index, for instance, is a passive fund that uses market capitalization.

But some fund managers seeking higher returns — without having to pick stocks actively — have created investment portfolios based on other measures, such as a stock’s volatility, or a company’s dividends, sales or cash flow.

Interest in these alternative strategies is rising. According to a Morningstar report in May, assets in smart beta strategies increased by 59 percent last year, and over half of that growth came from new money.

This spring, Russell Investments introduced a suite of smart beta indexes. These include indexes to measure stock characteristics like value, quality, momentum and low volatility, and others focused on different ways to weight stocks in an index.

Yet smart beta is still an investing niche, despite all the attention it has garnered. Morningstar said that at the end of last year $291 billion was in smart beta strategies. And in its current incarnation, smart beta has been around for only about 10 years.

Its very name is confusing to many. In investing jargon, beta is the market return, like the 30 percent or so the S.&P. 500 returned for an investor last year who owned the index from Jan. 1 to Dec. 31. Alpha measures what a fund returns above a market benchmark. The first is passive, the second requires active selection.

Smart beta is more passive than active. Once the investment criteria are chosen, the strategy passively follows the rules that have been set, like investment in low-volatility stocks that are part of the S.&P. 500.

Rob Arnott, chairman of Research Affiliates, considered to be the pioneer of indexes that do not weight market capitalization, said one secret of the sauce was not buying stocks just because their price was rising. “Why would we want something to be part of our portfolio just because it went up in value?” he asked. “If something is twice as expensive, why should we have twice as much exposure to it?”

What his firm calls fundamental indexing looks at a company’s sales, cash flow, book value and dividends paid to shareholders. “We make the supposition that those four measures are a very different economic footprint of a business,” he said. They also make a company like Apple, with its sky-high market capitalization, a lot less important to an index.

Other smart beta strategies have fewer variables. Stephen Sachs, head of capital markets for ProShares, said one of his firm’s most popular smart beta exchange-traded funds, the S.&P. 500 Aristocrats E.T.F., consisted of the companies in the index that had increased their dividends for at least 25 years in a row. There are 54 and the E.T.F. holds the same amount of all of them.

“The index itself is simple,” he said. “The idea is you’re looking for S.&P. exposure but you like the concept of dividend growth because we know over the long term, dividends make up a lot of the return.”

Investors are interested in these strategies for different reasons. Tom Goodwin, senior research director at Russell Investments, said the firm surveyed 181 big investors in Europe and North America and found that the top two motivations were reducing risk and increasing returns. Costs, which are lower with E.T.F. strategies, were at the bottom of the list, he said.

Yet the rationale for smart beta, at least what Russell found, is fairly anodyne. What investor wouldn’t want higher, less volatile returns? Like many things today, the increase in interest for smart beta over the last few years has come from a shift in mentality after the recession.

“Smart beta strategies are gaining ground now because they’re marketed and perceived as quasi-passive strategies,” said Paul Bouchey, managing director for research at Parametric, a firm that specializes in creating customized portfolios for high-net-worth clients. “People feel they’re back-tested and can just put a lot of money into it. It’s different than if an active manager comes to you and says, ‘I have an idea.’ ”

Mr. Arnott said it took Research Affiliates, which licenses its strategy to managers like Pimco, from 2004 to 2012 to reach $75 billion in assets managed with its strategy. From 2013 to today, those assets have risen to $130 billion. “Before, these were viewed as a kind of niche strategy — peculiar, mildly interesting,” he said. “Now people realize that if you link the weight to the price, you’re going to load up on overvalued companies. When you sever that link you do better.”

But some investment managers seem to have almost an antipathy toward the very notion of smart beta. James Montier, a member of the asset allocation team at GMO, an influential investment management firm, wrote in a white paper titled “No Silver Bullets in Investing” that smart beta was “dumb beta plus smart marketing.” He challenged the basis for the claims made by Mr. Arnott and others of better returns when an index is not weighted by market capitalization.

Mr. Montier says the alternative weighting replaces large capitalization companies with small capitalization companies and those considered to be value stocks, not growth stocks — both of which are established ways to invest. “When these strategies are corrected for their exposure to ‘value’ and ‘small,’ they exhibit no statistically significant outperformance compared to the cap weighted benchmark.”

He pointed out that even the smart beta screens for quality companies could be flawed. Such companies are good investments only at the right price, as investors learned with the Nifty 50 bubble in the 1970s. “No asset (or strategy) is so good that you should invest irrespective of the price paid,” Mr. Montier said.

Even for people who believe smart beta has many great attributes, there are caveats. Michael Arone, chief investment strategist for the intermediary business at State Street Global Advisers, pointed to four. The first revolves around measuring how well a particular smart beta strategy performs.

“When you choose different risk premiums and different types of things, it’s important to understand exactly what exposure you’re getting and the likely payoff you’re getting,” he said.

He was also concerned about whether investors understood what smart beta actually was, and how well the strategies would hold up in different types of markets. And as interest in smart beta grows, there is a fourth risk: the race to create more strategies will increase their complexity. “Keeping the strategy straightforward and all the components about traditional passive investing is incredibly important,” Mr. Arone said.

Putting aside the high-minded talk about the strategies behind smart beta, there is the obvious question of what its opposite would be, dumb beta. It would not be people who invested in a passive index fund but those who bought stocks that were rising because they believed they would continue to rise, Mr. Arnott said.

Mr. Bouchey agreed about the potential for confusion caused by the term smart beta. “These strategies are not implemented by smart humans,” he said. “They’re implemented in a rules-based way. The word beta has been co-opted from something that is not market cap weighted.”

In the end, a better, if less marketable way to think about smart beta might be to call it “lazy alpha” — since once the criteria to screen the holdings have been chosen, the strategy is allowed to run its course.