Smart beta strategies can fail to live up to their promised outcomes in performance, diversification and stability, according to some in the investment management industry, challenging perceptions to an increasingly popular alternative to passive market-capitalization-weighted indexes.
“Smart beta strategies exhibit all the characteristics of a great fad as measured by the growth of media attention, proliferation of products and the surge of assets,” said Bruce I. Jacobs, principal, Jacobs Levy Equity Management Inc., Florham Park, N.J. “Fads can lead to unwelcome outcomes.”
In addition, smart beta strategies deepen asset owner involvement in portfolio management decision-making, having them take on more responsibility than setting asset allocation and selecting investment managers, he said.
“Smart beta strategies require the plan sponsor to make active decisions as to which factors to bet on,” Mr. Jacobs said. “The plan sponsor is taking responsibility for that decision as opposed to hiring an investment manager who would have that responsibility.”
Eugene L. Podkaminer, senior vice president, capital markets research, Callan Associates Inc., San Francisco, said: “My complaint, if you will, is that the marketing and the naming (of smart beta) have really obscured what's going on under the hood. As an economist and a practitioner and an adviser, that really irritates me.”
“My clients and my investors demand to understand what these strategies are really all about, how are they different than what's in their portfolio already and how are they accretive or additive to either enhanced return or enhanced diversification,” Mr. Podkaminer said. “And it is not intuitive how that is the case with smart betas unless you really start to dig.”
In a research paper on the issue, Mr. Podkaminer said, “One of the really important takeaways for investors is that because the way smart beta indexes are constructed, they pull from the same universe of stocks as traditional cap-weighted indexes and you don't see a lot of diversification benefits.”
”So there is a lot of hype around smart beta,” Mr. Podkaminer said. “It promises to do all these wonderful things but when you dig deeper into the construction methodology and the empirical results, you find there is a lot of overpromising.”
Mr. Podkaminer doesn't reject smart beta strategies. But, he said, “I want my clients ... to go in with both eyes open.”
“Many of these products are little more than a repackaging of small-cap and value effects,” said Mr. Jacobs, whose firm manages $9.1 billion in U.S. strategies, including long equity, defensive equity, 130/30 long/short and market-neutral long/short. “Once you account for small cap and value, you account for most of the (performance) value” in smart beta strategies, he said.
In addition, such active strategy managers “can close their strategies when they reach capacity limits for assets under management. Smart beta managers know no asset bounds,” Mr. Jacobs said. “Even if a manager chose to limit the amount it would manage, because these are public factors other managers would use that capacity ... there is no way to control the volume of investment in smart beta strategies.”