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.

Baskin-Robbins
According to fund research firm Morningstar Inc., as of year-end 2014 there were 394 smart-beta––or strategic beta (its preferred term)––exchange-traded products in the U.S., with more than $402 billion in total net assets. That’s up from 352 funds with nearly $320 billion in assets the prior year, and 211 funds with $133 billion in assets in 2010. And as of the end of last year, such funds represented 20% of all U.S. ETP assets.

Smart beta’s various flavors make it a veritable Baskin-Robbins. As described in a Morningstar report on smart beta released in September, some are return-oriented strategies that seek to boost returns relative to a standard benchmark by employing size, revenue, earnings, momentum, quality (companies thought to have durable business models and sustainable competitive advantages) or other standards. Other strategies employ risk-oriented methods that aim to reduce or raise risk levels relative to a benchmark by employing low-volatility or high-beta strategies, for example. Most smart-beta indexes apply to equities, while others exist for fixed income, commodities and multi-asset classes.

Russell Investments offered its own definition of smart beta in a report it issued in October: transparent rules-based indexes designed to provide exposure to specific factors, market segments or systematic strategies.

Either way, there are no hard-and-fast rules determining what should or shouldn’t be included under the smart-beta banner. Some strategies, such as equal-weighting, are straightforward; others are complicated. And the picture gets more clouded as new smart-beta-related products roll off the assembly line.

“Many of these indexes have short track records when they’re picked up by an investable product,” says Ben Johnson, Morningstar’s global director of passive funds research. “It’s a diverse group that’s growing increasingly complex, which brings a steeper learning curve for investors.”

A prime example is the DoubleLine Shiller Enhanced CAPE mutual fund, a smart-beta offering launched in 2013 that comes with a lot of moving parts. The fund marries DoubleLine’s fixed-income expertise and an index based on economist Robert Shiller’s CAPE (cyclically adjusted price-earnings) ratio for assessing stock valuations. It aims to deliver a total return in excess of the Shiller Barclays CAPE US Sector TR USD Index by maintaining a core portfolio of debt instruments focused on global fixed-income sector rotation, with part of the holdings pledged as collateral against derivatives exposed to the most undervalued sectors in the stock market as measured by the CAPE ratio. The fund employs a momentum factor to mitigate the effects of potential value traps.

It’s complicated, yes, but at least in its full year in existence the fund’s retail share class product did well with a 17.70% return in 2014. It comes with a 30-day SEC yield of 3.19% and a net expense ratio of 1.24%.

In response to both the growing number of smart-beta-related products and their increasing complexity, the Financial Industry Regulatory Authority has included ETPs based on alternatively weighted indexes on its 2015 regulatory priorities list. Finra’s concerns include potentially high trading costs on indexes that are thinly traded and have wide bid-ask spreads; their potentially higher turnover and transaction costs versus traditional indexes; and questions about how indexes backed by impressive back-tested performance numbers will actually perform in the real world in different market environments.

Active? Passive? Does It Matter?
In describing how he developed fundamental indexing, Arnott notes that equal weighting goes back to the early 1990s, and minimum variance goes back to the 1970s with Robert Haugen. “Yet neither gained much in the way of assets until fundamental index came along,” he says. “Introducing that angered a lot of the traditional indexing and academic communities.”

Back in the ’90s, Arnott explains, he was troubled by cap-weighting and thought weighting companies by market capitalization would guarantee that if a company was overvalued and trading above its eventual fair value, it would also guarantee that your exposure to that company was higher than its fair-value weight.

“It’s a truism, but it’s also useless because you don’t know what fair value is,” he says. “But it occurred to me that if you weighted on something other than price or market cap, such as sales or book value, you’d eliminate that bias and would probably add some value. I didn’t test the idea until 2003.”

Arnott and his team looked at various measures and eventually realized it doesn’t matter which measure you use. “Fundamental index alpha has nothing to do with the fundamentals,” he says. “It has everything to do with severing the link with price, and it’s that mere fact of severing the link that adds value. Cap weighting basically says the higher the price of the company, the higher its future expected return must be; otherwise, it wouldn’t justify a higher weight. That doesn’t make sense.”

Of course, not everyone agrees. “The price of a security reflects the consensus estimate of every investor involved in the market,” says James Rowley Jr., senior investment analyst at Vanguard. “At any given time, a security’s price is the market clearing price, and investors arguably are looking at every potential metric or factor to determine that price. To us, any individual price times the number of shares gives a company’s market capitalization total, and that price is the most unbiased estimate of a company’s value.”

In a report he co-wrote last year on active indexing, Vanguard posits that smart-beta, or non-cap-weighted index strategies that try to outperform the market on the basis of systematic exposures or tilt strategies, are essentially active management.

The upshot, according to Vanguard, is that the efficacy of such alternatively weighted portfolios heavily depends on how consistently and cost-effectively the systematic exposures are captured. “Investors who use such strategies face uncertainty relative to the broad market as well as to their targeted exposures,” the report said. “As a result of this active choice, the source of active management is transferred to the investor.”

Smart beta represents a gray area between passive and active management, which makes it a hot debate topic among academics and investment portfolio wonks.

“Smart beta is the offspring of active and passive parents because it combines elements of both,” Morningstar’s Johnson says. “Like its active parent, embedded in the index methodology of the underlying benchmark there’s this active bet against the market. So this strategy deviates from traditional market exposure. And like its passive parent, these are transparent, rules-based and for the most part relatively low-cost investment products.”

Some people think the academic debate of active versus passive regarding smart beta is just that—academic. “My short answer is that it doesn’t matter much,” Arnott says. “The longer answer is passive is in the eye of the beholder. If you have a cap-weight-centric worldview, which the academic and indexing community does, this is unequivocally an active strategy. They say it’s not cap-weighted, so it can’t be passive—it is active.

“I totally get why the academic community dislikes the term smart beta,” he continues. “I’ve talked to Bill Sharpe about it, and he says it’s alpha, not beta, and alpha can go away. My response is it’s a way of getting your beta which appears to have a reliable alpha attached to it, which is what makes it smart.”

What lies at the heart of the matter is that Arnott has often voiced far more skepticism about market efficiency than many academics. “Gene [Fama] acknowledges that the market has imperfections, but he is very wary that the imperfections are structural and that they can be exploited for profit,” Arnott says.

Realities Of Smart Beta
The rise of smart beta has generated excitement—and perhaps some misplaced expectations among some investors.

RIAs who have employed indexing for decades agree that Arnott is onto something even if they dislike the term smart beta. “Some strategies are sound and some are pure marketing,” says Harold Evensky, CIO of Evensky Katz/Foldes Financial. “It’s a question of overweighting certain factors.”

Dimensional Fund Advisors (DFA) has been developing similar products for decades. Just as fundamental indexing is a way to underweight overvalued large-cap stocks, DFA’s price-to-book value fund is a way to underweight companies engaged in aggressive accounting.

“These various strategies and risk premiums have shown they can generate excess returns over long time periods, but those periods can be as long as 10 to 20 years, during which they could have periods of underperformance,” Johnson says.

In other words, smart beta won’t magically produce a smoother ride. “Fundamental index doesn’t actually dampen volatility,” Arnott says. “Over long time periods, its volatility is nearly identical to the market’s volatility—they’re within 20 basis points of each other in terms of volatility over the past 50 years.”

Arnott notes that fundamentally weighted indexes have outperformed market-cap-weighted indexes in the U.S. since the market low in 2009, but they have been more neutral since late 2009 because most of that year’s spectacular outperformance happened in the middle half of the year.

“In most of this bull market, as is the case in a lot of bull markets, growth has outpaced value,” Arnott says. “And whenever growth is winning, fundamental index does have a value tilt relative to cap weight, so when growth is beating value we’ll have a headwind. But relative to value managers during the past five years who’ve been hit hard, and despite the value tilt of fundamental index, it has held its own against cap-weight.”

In short, Arnott explains, bear markets that involve a financial crisis and a flight to safety are ones where fundamental indexes won’t necessarily help investors. But bear markets that are revolts against excessive valuations are where growth stocks get crushed and where fundamental indexes win handily.

“Fundamental index works best when value is winning and when the market is thrashing about on which bets to make,” he says. “It struggles when the market is trending and systematically rewarding growth over value.”

As for costs, smart-beta funds look pricey versus traditional bulk-beta, vanilla cap-weighted ETFs providing broad U.S. equity exposure for four or five basis points. “Smart-beta strategies that kind of troll in the same waters with broad U.S. equity exposure but with a more complex methodology, and charge a fee of 30 to 40 basis points, are more expensive on a relative basis vis-à-vis more traditional passive funds,” Johnson says. “But when framed against traditional active managers, in a lot of cases they’re a fraction of the cost.”

He offers that smart beta represents a more democratic evolution in factor investing by providing a systematic, low-cost product in an ETF wrapper that’s available to both large institutions and small individual investors.

At the end of the day, smart-beta indexes compete against both cap-weighted indexing and active management. Which raises the question about whether smart beta poses an existential challenge to either one.

“If anything faces an existential challenge, it’s active management,” Arnott says. “But viewed from the sense of indexing in its classic context of cap weighting, it’s got a bit of an existential challenge because those who refuse to accept the idea that maybe you can do better in a systematic, disciplined way with high odds of long-term success may be locked into a slowly diminishing market share.

“But I harbor no illusions that fundamental index or smart beta will eclipse cap weighting in terms of market share in my lifetime,” he adds. “There’s a lot of inertia in our business, and things change slowly.”