© 2020 Arizent. All rights reserved.

Why smart beta may not be so smart

Register now

DANA POINT, California - Investors are data mining and chasing performance when it comes to smart beta factor investing. That’s according to Rob Arnott of Research Affiliates, who I consider the founder of the smart beta movement, as many smart beta funds are based on Arnott’s RAFI indexes. I was quite surprised the first time Arnott told me that.

Past is not prologue according to Arnott, who spoke at the INN Global Indexing and ETFs Conference. With the proliferation of smart beta and factor strategies, investors should be vigilant to the pitfalls of data mining and performance chasing. Arnott noted that 500 factors have been published so far – and all factors worked in the past. All had statistical significance. Trend chasing is everywhere. Still, past alpha can’t be relied upon in the future.

I couldn’t agree more with Arnott’s points as I’m not aware of any new fund launched that didn’t work on a back-tested basis. But Arnott seemed to imply there were good and bad times to move into smart beta funds.

What wasn’t mentioned was the fact that, according to Morningstar, small cap and value factors have underperformed over the past five years. And that’s before costs. A couple of years ago, I wrote about why I’m remaining a “dumb beta” investor. Arnott contacted me and correctly told me he had never called market cap weighting “dumb.”

My view is that whenever any investing style becomes too popular and money pours in, future returns are likely to lag. I tend to agree with Dimensional Fund Advisors that factors represent additional expected returns as compensation for taking on more risk. They are not a free lunch!

I’m remaining a market-cap weighted investor because it’s the most tax-efficient and lowest cost strategy I know. Further, it has one additional benefit in that a broad total market-cap weighted index fund must mathematically beat most money invested in that market. I’ve found that clients value knowing this.

Though I applaud Arnott for showing the pitfalls in smart beta, I consider smart beta to be an active strategy. And while far better than most active strategies, I’m going to resist the urge to complicate and stick to simple investing.

But if at some point in the future I need to make a fortune, I’ll launch my own series of “brilliant beta” funds. All will be based on factors that failed miserably on a back-tested basis under the theory that reversion to the mean will predict outperformance. Of course, it will be better for me as the fund provider than for investors.

For reprint and licensing requests for this article, click here.