Indexing’s Existential Controversy

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.”