Early in 2000, Rob Arnott found himself discussing the state of the equity market with George Keane, the venerable founding CEO of the Common Fund Group.

Keane, who had spent more than three decades in the institutional asset management world, voiced fears about pensions frustrated with active management reallocating assets into the market-cap-weighted S&P 500 index. As a board member of the New York state pension fund, he noted the result would be to allocate 4% of its assets to Cisco, the darling of Wall Street. The contrarian Keane viewed it as a relatively small company with 25,000 employees.

Within 18 months, Cisco had lost more than half its value, and soon Keane was working with Arnott’s new firm, Research Affiliates, to develop a fundamental index that investors could substitute for the S&P 500. That research would culminate in a March/April 2005 article in the Financial Analysts Journal called “Fundamental Indexation” written by Arnott and two colleagues, Jason Hsu and Philip Moore.

In the article, Arnott and Co. took issue with the fixation of “Wall Street” on market capitalization, focusing instead on “Main Street” measures of a company such as its gross revenues, equity book value, gross sales, gross dividends, cash flow and total employment. They claimed to “show that the fundamentals-weighted, non-capitalization-based indexes consistently provide higher returns and lower risks than the traditional cap-weighted equity market indexes while retaining many of the benefits of traditional indexing.”

Fast-forward 10 years, and smart beta—a broad-based description encompassing various strategies like fundamental indexing that aim to provide better risk-adjusted investment returns than traditional market capitalization-weighted indexes—is all the rage in the investment universe. As a concept, it’s become a bit of a lightning rod for criticism and, just maybe, the next big investment wave (even though its roots go back several decades).

For better or worse, the term describes a growing subset of the investing world, as witnessed by the ever-expanding number of exchange-traded products (ETPs) marketed as smart beta. But “smart beta” is a term many people don’t like. To quote a paper from Russell Investments that quotes from The Economist, “Terrible name, interesting trend.” William Sharpe, who won the Nobel economics prize for his capital asset pricing model—creating the notion of “beta” to measure a portfolio’s sensitivity to the overall market—recently remarked that from a definitional perspective, the term smart beta “makes me sick.”

The list of skeptics evidently also includes Nobel laureate Eugene Fama, father of the efficient market hypothesis, and Burton Malkiel, the Princeton University economist and author of the classic book A Random Walk Down Wall Street. Both academics have remarked that smart-beta portfolios are more about smart marketing than smart investing.

Much of the academic community was offended by the suggestion that a portfolio could be created that could earn a structural alpha. If possible, the tacit implication was that markets were inefficient. And even Arnott, a prime mover and shaker in the so-called smart-beta movement, questions the rigor of the term.

“I don’t mind the term, even though I recognize from a theoretical perspective that it’s sloppy,” he says. “But it’s also fun and provocative.”

What makes smart beta so “smart”? “It’s not that it’s a different kind of beta, it’s that it’s a smarter way to get your beta. That’s a nuance,” says Arnott, chairman and CEO of Research Affiliates LLC, a Newport Beach, Calif.-based money manager with nearly $180 billion in assets under management. While Arnott’s firm has been a pioneer in smart-beta strategies (though neither he nor his firm coined the term), its fundamental index methodology underpins numerous indexes from the likes of FTSE and Russell and provides benchmarks for exchange-traded funds from PowerShares, Charles Schwab, Pimco and a host of start-ups, such as RevenueShares.

The FTSE RAFI index series, for example, weights constituents based on a composite of fundamental factors such as total cash dividends, free cash flow, total sales and book equity value. The Russell Fundamental Index Series are weighted according to fundamental measures such as adjusted sales, operating cash flow and dividends plus buybacks, among others.

The basic gist of smart-beta strategies is to break the link between the price of an asset and its weight in a portfolio, a phenomenon smart-beta proponents say leads to outsized concentrations of larger, more expensive stocks in cap-weighted indexes and the funds that track them.

“The goal [of fundamental indexes and other smart-beta strategies] is to no longer anchor on price and to no longer load up on companies just because they’re expensive. Why should we do that?” Arnott asks. “Any sensible process says to buy low and sell high. It shouldn’t be to commit more of your money to an asset just because it’s expensive, and that’s what cap-weighting does.”

Sounds good in principle, but do these strategies actually work? A 2013 report from Towers Watson studied six equity smart-beta strategies—ranging from minimum variance (or low volatility) to equal weighting—and found all six outperformed a U.S. cap-weighted index and did so collectively by an average of nearly 2% between 1964 and 2012. All six strategies also scored better in terms of standard deviation and risk-adjusted performance.

Much of that relied on back-tested numbers. But Arnott maintains that fundamental indexes have been road-tested in the market long enough to show they indeed add about 2% a year all over the world. “It adds more than that in the market’s less-efficient and more volatile segments such as small companies, global strategies and emerging markets,” he says. “We’ve found the less efficient the market and the more noise found in the price, the bigger the value added by any rebalancing strategy that … trades against price movement.”

In that pursuit, fundamental index strategies often tilt toward value and slightly toward small caps. Skeptics of smart-beta mania thus claim it’s essentially nothing but good old-fashioned factor tilting and not some new-age wonder strategy.

Arnott himself acknowledges there are market environments when cap-weighted indexes will outperform, particularly in those stages when the market’s leadership is concentrated in a handful of large-cap stocks, as it was in Cisco, Microsoft and GE in the late 1990s and, more recently, Apple. Since the financial crisis, the extra return earned using fundamental indexing in emerging markets has narrowed dramatically, a development Arnott attributes to “the monumental flight to safety” in those markets.

But whatever you want to call it and whatever its roots are, non-cap-weighted strategies have caught the fancy of the investing public. And the growing popularity of smart-beta strategies has reached the point where a panel discussion at an investing conference last month focused on the central question of whether traditional cap-weighted indexing faces an existential crisis. It’s a provocative notion that’s probably a little over the top. Nonetheless, it’s clear that smart beta is here to stay and will likely become more prevalent.

First « 1 2 3 4 » Next