The US Securities and Exchange Commission last year sought public suggestions on smart beta labelling © Bloomberg

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A recent academic study suggested that many smart beta fund names are misleading, with half of smart beta products being essentially stock market index funds.

The prevalence of potentially misrepresentative names in investment funds has caught the attention of policymakers and regulators: the US Securities and Exchange Commission last year sought suggestions from the public on how to address this issue.

The problem is that there is no generally accepted definition for the term “smart beta”.

Fifteen years ago Towers Watson, a consulting firm now called Willis Towers Watson, coined the term smart beta to differentiate it from the “bulk beta” available in index funds.

The factor investing and the quantitative communities have since embraced the smart beta label. No wonder, as the phrase sells. Who doesn’t want to buy a smart product?

Absent a uniform definition, firms can attach the smart beta label to almost anything. At the end 2020, there were 1,300 funds in the smart beta universe with total assets of $1.2tn, according to Morningstar, the research group.

The crucial component in any useful definition of smart beta is breaking the link between a stock’s price and its weight in the portfolio. Any strategy that uses market capitalisation in selecting or weighting securities, such as a cap-weighted value index, is not smart beta. When we give more expensive stocks more weight in a portfolio, we hurt performance relative to valuation-indifferent indices.

Rob Arnott © Bloomberg

The same can be said of many cap-weighted factor strategies, including quality or low volatility. Momentum, which amplifies the link with price, would also not be smart beta under the original definition of the term. An investor is forced to allocate more of their portfolio to overvalued stocks and less to undervalued stocks: a buy-high, sell-low approach.

Our research has found that, empirically, any structure that breaks the link between price and weight outperforms cap-weighting in the long run, because the former automatically benefits from a contrarian rebalancing effect that exploits stock price mean reversion. Even a nonsensical or whimsical non-price-based portfolio (darts, anyone?) will typically outperform cap-weighting for that reason.

Given the wide-ranging availability of investment vehicles labelled as smart beta — including many that are not at all smart except for the label — investors may want to rely on a few tools and practices both to avoid pitfalls and raise the odds of meeting their long-term investment goals.

First, ensure the return premium expected from a smart beta strategy is robust. Factors underlying smart beta strategies should be grounded in common sense and careful academic research. They should add value all over the world and should not rely on a specific narrow definition in order to work. A framework can help investors identify and narrow the range of choices when deciding which smart beta strategies to consider.

Second, be sure to counter the behavioural biases of trend chasing and ill-timed buy and sell decisions. During spans of underperformance when instinct says “sell”, revisit whether the strategy’s economic rationale remains intact. This reiterates why the strategy was expected to deliver in the first place.

It is also worth querying whether the results of the strategy can be captured in the real world of trading costs and frictions. Various elements of product design, such as portfolio concentration, turnover, liquidity, size, and number of holdings, can affect trading costs, with the potential to erode our results.

Third, research whether a particular strategy is trading cheap or rich relative to its history. Anything with soaring performance often creates an illusion of superiority while anything newly cheap likely got there by delivering pain and losses, which tempts us to buy high and sell low. Also, recognise that in a historical test of performance, a meaningful portion of past returns may be tied to revaluation changes, so any analysis must control for valuation levels.

For investors with long investment horizons and a willingness to tolerate uncomfortable portfolio rebalancing trades, smart beta strategies can help achieve investment objectives. Sadly, mislabelled fund names and the lack of an aligned definition around these strategies mislead and obscure.

Until smart beta sees more transparency and is more clearly defined, these practices can serve to keep us off the rocks as we navigate this fast growing space.

Rob Arnott is founder and chair of Research Affiliates, a global asset manager

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