If it relies on ‘dumb beta’ to work, it will be eliminated over time
How smart is Smart Beta really? Does it depend on Dumb Beta staying dumb and never wising up?
Those lucky enough not to speak fluent financial jargon could be excused for not understanding these sentences. But they cut to the heart of the debate over how to attempt to beat the stock market.
Beta, in this sense, is a term from capital asset pricing. It is a coefficient that captures the extent to which a stock is sensitive to the market. A stock with a beta of 1 moves exactly in line with the market at all times. The market itself has a beta of one. (Alpha is the variable that captures all market moves that cannot be explained by the market).
So in financial parlance, you can buy beta very cheaply by buying an index fund. Meanwhile alpha is elusive and comes at a price. This justifies the rise of passive index funds and exchange traded funds. They give you beta, cheaply.
But index funds are dumb, accepting prevailing valuations unthinkingly. So why not offer index-like fund management that works automatically, and so keeps costs down, while exploiting anomalies in stock valuations to try to beat the index? Variations include weighting stocks by earnings, or dividends, or their risk – all measures designed to buy more stocks when they are undervalued.
This is what “smart beta” means, and it is flavour of the month. Index providers such as Russell and Standard & Poor’s now offer smart beta indices. Big institutions offer smart beta funds.
But does it work, why does it work, and how long can it keep working?
‘Definitionally sick’
The most trenchant critic is the Stanford University economist Bill Sharpe, who won a Nobel Prize for his work defining the concept of beta. He says smart beta makes him “definitionally sick”. He reasons that smart beta strategies are either factor bets – betting on cheap or small stocks to outperform – or an active attempt to beat the market (which would class them as “alpha” not “beta”)....MUCH MORE
