A Land Where Everyone Is Above Average

Journal of Financial Planning: March 2015


Rick Ferri is author of The ETF Book. He continually monitors and evaluates the latest trends related to index funds and ETFs. His research appears frequently in many major media outlets.

Alpha for everyone, that’s what we see. Almost a guarantee, as close as it can be. 

The title of my poem is “Smart Beta Hope” and I dedicate it to all those promoting so-called “smart beta” investment strategies. They believe their products are superior to the market and will provide unlimited outperformance for everybody. 

As I listen to the growing chorus of smart-beta advocates, I wonder if they live in Lake Wobegon, the fictional town in Minnesota popularized by NPR’s Garrison Keillor. It’s a special place where, “All the women are strong, all the men are good looking, all the children are above average, and everybody beats the market.” I added that last part. 

Let’s start by explaining beta. Portfolio beta, as defined by Nobel Laureate William Sharpe, is the non-diversifiable risk of an entire market. In other words, a portfolio of stocks has risk because it’s a portfolio of stocks. 

The market beta is 1.0 by default. A stock portfolio’s beta is its return sensitivity to this risk. A portfolio with a beta of 1.2 has more market sensitivity than a portfolio with a beta of 0.8. Risk is a proxy for expected return. Thus, the high-beta (low-beta) portfolio is expected to earn higher (lower) return than the market in the long term. 

The attention-grabbing phrase “smart beta” isn’t about market risk; it’s about other risks and the sensitivity of a portfolio to those other risks. These risks include, but are not limited to, company size, price momentum, and value factors such as low price-to-book ratios. However, rather than represent these risk factors for what they are, the strategies are promoted as “smart,” by product creators. In my view, cloaking risk with fancy names creates the risk of chasing hot ideas. 

Sharpe does not agree with calling these extra risk factors smart beta: “I tried many years ago to get people to use the term ‘b’ for the coefficients in a factor model, such as one in which the factors are value, size, etc. However, the industry and some academics have muddied the waters by using ‘beta’ for such factor loadings,” he’d said in a 2013 article I wrote that ran in InvestmentNews and Forbes

Rob Arnott of Research Affiliates is less troubled by the terminology and for good reason. His firm is a leader in smart beta indexes and creator of the Fundamental Index (RAFI), a strategy that weighs securities using fundamental factors other than market capitalization. More than $170 billion is tracking RAFI strategies worldwide.

Smart beta advocates point to back-tested strategies as proof of their superiority. Critics point to their proof as data mining. But even if it were true, it’s also true that whales coming up to spout get harpooned.

“Nothing fails like success,” John Bogle once said in a 1997 speech, addressing asset bloat that’s common in outperforming investment strategies. “Clearly, huge performance premiums were earned in the early years, only to regress to the market mean in the mid years, and finally below the mean in the years of giant size.”

Money is pouring into smart beta strategies, and their marketing success may be their demise. The risk of asset bloat has a special name in this space. It’s called “factor crowding,” when too many dollars chase a limited supply of opportunities. Crowding reduces the spread between supposed undervalued securities and their counterparts until the spread becomes so thin that there’s not enough to cover the higher management fee. At that point the strategy underperforms. 

I’m not against factor investing; I’m against bad marketing. Be well aware of these facts if you add extra risk to a portfolio. First, any excess earned must first overcome the extra cost; second, greater mass-market participation leads to factor crowding and lower expected premiums; and third, there are long periods when these strategies do not work. The smart thing to do is to proceed with caution.

Performance data shown represents past performance, which is not a guarantee of future results. A decision to invest in any investment fund should not be made in reliance on any statements set forth in this article.

Investment Planning