Is Smart Beta Really Smart?

There is a popular new investment strategy in portfolio management called smart beta. With a catchy title and a promise of improved portfolio performance, the strategy has already attracted hundreds of billions of dollars and is growing by leaps and bounds. Unfortunately, smart beta portfolios do not consistently outperform and when they do produce appealing results, they flunk the risk test.1

WHAT IS SMART BETA?

There is no universally accepted definition of smart beta strategies. What most people who use the term have in mind is that it may be possible to achieve greater-than-market returns using a variety of relatively passive investment strategies that involve no more risk than would be assumed by investing in a low-cost total stock market index fund, which, by definition, has a beta of one. They claim that one doesn't have to be a stock picker, as most active managers are, to be able to beat the market. Rather, you can manage a relatively passive (low turnover) portfolio to accomplish good results more dependably without assuming any extra risk. And you can do so at a fee well below that charged by active managers. The trick is to tilt (or flavor) the portfolio in some direction such as value versus growth, smaller versus larger companies, relatively strong stocks versus weak, and low-volatility stocks versus high volatility ones.

Other tilts or flavors that have been suggested include quality (encompassing attributes such as stable sales and earnings growth and low leverage), profitability, high dividends, and liquidity. Just-as-good cooking blends a number of food flavors, some smart beta portfolios mix two or more flavors together. There are portfolios that blend value and small size as well as those that mix several of the flavors mentioned above. Moreover, all this can be accomplished without increasing the expected volatility (beta level) of the smart beta portfolio.

Smart beta strategies are related to multifactor models of asset pricing. If one assumes that the beta of the capital asset pricing model (CAPM) is an incomplete measure of risk, the tilts or flavors listed above can be considered as additional risk factors. By tilting the portfolio toward smaller companies, for example, the investor is making a bet that the risk premium that is available from smaller companies can...