Wall Street Steward Blog

Smart Beta is Stupid

Ok, let’s simplify this. Beta is “market return,” while Alpha is “value added return.”

In the active vs passive debate, these two terms are relatively simple to understand. Allow me to explain:

Assume the S&P 500 returns 10% in 2014. If an active manager returns 13%, then his/her returns typically can be explained like this:

10% = the return of the investment due to “the market”
3% = the “value added” return due to active management decisions

Obviously, there is much more to it than that, but it gives you an idea of what the terms mean. Passive investing disciples believe in using low cost index investments, so that your portfolio achieves “beta” returns, whereas active managers strive to add value, or to add “alpha,” by actively managing the investment. Passive folks argue that since most active managers do not beat their index, they will gladly take the index returns in exchange for keeping costs low, and therefore, over time, earn a high risk-adjusted rate of return. Active folks simply say that most managers who claim to be active are “closet indexers,” and that if you remove those, it is not impossible to identify active managers who can consistently outperform their index.

Neither approach is wrong. Neither is “better.” I have no issue with either approach, although I do favor one over the other. For sake of this blog, I won’t disclose which I like better. My complaint is about this new phenomenon called “smart beta.”

Smart beta is the form of investing that starts with an index, and attempts to tweak that index to produce a greater return. This usually involves equally weighting the index (as opposed to cap weighting), or overlaying a screen for strong fundamentals, or even only buying the index components that have the best looking technicals. Etc, etc, etc….there are a thousand ways to slice and dice the data. Suffice to say that the underlying index is manipulated slightly. But, ONLY slightly…because if it were manipulated a lot, that would be active, right?

Start with index. Manipulate slightly. This is “smart beta.”

I don’t think it is smart. In fact, in my opinion, it doesn’t exist. It is a farce. ANY manipulation of an index, no matter how big or small, is a form of active management, and therefore is NOT beta, but an attempt to add alpha.

However, that hasn’t stopped publications such as this one from touting these ridiculous strategies.

The S&P 500 is comprised of 500 stocks.There is no difference between an active manager picking 25 of those for her portfolio and a company taking the 500, screening them for cash flows, and buying only the best 450. Both of these are active management – one more active than the other, yes, but both active.

You’re either active or you’re passive. Can’t be “kind of passive,” just like you can’t be “sort of pregnant.”

Start with index. Buy. That is passive investing, or “beta.”
Start with index. Manipulate a little. That is active investing, and an attempt to add “alpha.”
Start with index. Manipulate a lot. That is active investing, and an attempt to add “alpha.”
Have nothing to do with an index. That is active investing, and an attempt to add “alpha.”

To start with an index, manipulate it slightly and call it “smart beta” is really just “stupid beta.”  It is an attempt to sell you something new, which really is a farce.