Smart Beta? Sounds complicated. Almost certainly is.

Note: this is a follow-on post to “The Perils of Passive Investing“

Here is some advertising with buzzwords:

Investopedia has this un-exciting definition:

DEFINITION OF ‘SMART BETA’

Investment strategies that emphasize the use of alternative weighting schemes to traditional market capitalization based indices. Smart beta emphasizes weighting schemes based on fundamentals or market inefficiencies. The increased popularity of smart beta is linked to a desire for portfolio risk management rather than only investment return.

And what they mean by that is: “a active-passive investment invented by an active manager, which sounds dangerous, and almost certainly is, most of the time.”

The thought process in the mind of an active fund manager*:
*Just to remind you – the world is split into two kinds of fund. Passive funds are not managed by a human fund manager – they’ve got a robot that’s been programmed to make the fund investments match those of an index, or something similar. Active funds are managed by a human fund manager, who is hopefully smarter than all the other active fund managers, and also hopefully smarter than the dumb money in passive funds.

Look at this passive exchange traded fund.
There’s a lot of money invested in that passive exchange traded fund.
Look at all those fees that I’m not earning!
I wonder if there’s something that I could do to change that.
*ponders*
Okay, so, like, there are some problems with passive investment strategies.
For one thing, passive index tracker funds have a tendency to buy up shares that are overvalued by the market, and sell off shares that are undervalued by the market.
How do I know that some shares are overvalued and some are undervalued?
Well, mostly common sense and gut feel, if I’m honest…
But if I were justifying the decision to my investors, I’d use momentum indicators, dividend yields, market-to-book value ratios…
Hey – those factors sound like things that I could write into an algorithm!
¡¡¡IDEA!!!
I’ll take a passive index-tracker algorithm, and get it to weight things differently depending on momentum indicators, dividend yields, and market-to-book ratios!
That’s not just earning the market beta.
That’s smart beta.
Also: less work for me, more money for me.
*immediately calls marketing department*

As I see it, this is an example of a very slow form of market efficiency. Market agents have realised that the passive index-tracker funds have the potential to create long-standing market inefficiencies. And this is their attempt to address it.

For example: if a stock is unliked by the market, then the passive index-tracker funds will all underweight it (ie. the stock price is damaged by the active investors, and then the passive investors double up the damaging). At this point, you’ll get active investors starting to say things like “this stock is undervalued – we should buy it” – but their renewed enthusiasm has to take on all the dislike that has been entrenched by the passive index-tracker funds – who are not really market agents so much as they are market replicators with a bit of a feedback loop. Really, what I’m saying is: the price-adjustment process is probably a bit sluggish.

So what is actually needed here are some contrarian passive funds that will counteract the über-conformist passive fund majority (you don’t get more conformist than an index-tracker fund, I’m afraid).

Hence the growing interest in “smart beta” contrarian passive funds.

And in principle: I’m a fan.

In practice, however, I have some concerns:

When dealing with a standard passive index-tracker fund, you don’t really need to understand the algorithm or the market.
And in any case, it’s relatively easy to understand – “Equities are quite risky; this tracks the equity index by making daily re-balancings; you’ll do as well as the market does; all for less cost than you would have to pay if you did it on your own. The rest is mostly detail that you don’t need to trouble yourself with.”
But with smart beta funds, you don’t really know what you’re getting: and unfortunately, the success of the fund is only as successful as the algorithm that it’s programmed with.
That is: an ex-active manager could set up a smart-beta fund, and decide “This will follow the market, except where the market-to-book ratio is above 6 or below 1, in which case, the weighting will be underweight by 40% if above 6, or underweight by 40% if below 1, unless this is a resource share, in which case the weighting will be underweight by 100% if above 4, underweight by 80% if above 3 by less than 4, and overweight by 60% if less than 1…”
And unless you’re the manager that decided on the rules, or a finance nerd, you’re not really going to know what the smart beta fund is doing, or what the completely arbitrary weighting assumptions mean (phrases like “underweight by 40%” are bizarre).
The thing is: the market is mostly comprised of people – who are not all rational investors with long-term investment horizons.
Codifying responses to the randomness of the markets seems like dangerous territory to me.
As in: you can have some basic principles for dealing with the market, but the minute you do too much of it, you’re asking for trouble.
Also: feedback loops. Which make the whole exercise look like you’re dealing with chaos theory.

So here are my take-home thoughts: