The term smart beta grew out of attempts by people in the industry to explain the Fundamental Index approach vis-à-vis existing passive and active management strategies. When Towers Watson, a leading global investment consulting firm, coined the expression smart beta, it was not their intent to label cap-weight as “dumb beta.” Indeed, they referred to it as “bulk beta,” because it could be purchased for next-to-nothing. There is nothing “dumb” about cap-weighted indexing. If an investor wants to own the broad market, wants to pay next to nothing for market exposure, and doesn’t want to play in the performance-seeking game, cap-weighted indexing is the smartest choice, by far. People are beginning to understand that the dumb beta is the fad-chasing investor who buys whatever is newly beloved and sells whatever is newly loathed, trading like a banshee. Fortunately or unfortunately, these folks are legion, as is well documented in Russ Kinnel’s important “Mind the Gap” white papers (2005, 2014).
As the debate over the smart beta label grew, Towers Watson (2013) sought to clarify the meaning of their expression with the following definition:
“Smart beta is simply about trying to identify good investment ideas that can be structured better… smart beta strategies should be simple, low cost, transparent and systematic.”
This straightforward definition indicates what investors ought to expect of a smart beta product. Our research suggests, however, that many alternative beta strategies fall short of this definition. Some are overly complex or opaque in the source of value added. Others will incur unnecessary implementation costs. Many so-called alternative beta strategies don’t seem so smart, by Towers Watson’s definition.
The problem may be that even this definition is not clear enough. The absence of a rigorous, generally accepted definition gives me-too firms enough latitude to stamp smart beta on anything that’s not cap-weighted indexing. The way the term is bandied about, without much regard for meaning, is a disservice to investors.
We don’t presume to define smart beta for the industry, but we would like to see more consistency in how the label is applied. Our definition builds on the Towers Watson definition, adding more specificity as it relates to equity strategies, where the smart beta revolution began almost a decade ago:
A category of valuation-indifferent strategies that consciously and deliberately break the link between the price of an asset and its weight in the portfolio, seeking to earn excess returns over the cap-weighted benchmark by no longer weighting assets proportional to their popularity, while retaining most of the positive attributes of passive indexing.