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.”