One of the latest, and disturbing, trends in the financial markets is the push to find 'smart-beta'. To explain, 'alpha' is the average market return, whcih in the share market is usually very good over time. 'Beta" is an additional return above that average. This is what fund managers pursue, and there is almost no evidence that they are able to achieve it. If they succeed in beating the market in one year, then they will almost inevitably fall below the average in the next year. Worse, the more they charge for their services, the more they will fall below the average market return.
Now, companies are trying to use algorithms to achieve beta. There are almost 400 smart-beta funds in the U.S. right now, and they account for $400 billion, or 20 percent of all assets, in domestic ETFs, according to Bloomberg Intelligence. That’s up from zero in May 2000, when the first prototypes—one iShares ETF aimed at growth and another at value—marched out of the lab and onto exchanges.
An article on smart beta describes what is going on:
"Like any Wall Street bonanza, this one has drawn imitators, innovators, and possibly a few hucksters, according to the U.S. Financial Industry Regulatory Authority, which included smart beta on a list of eight product categories that it plans to scrutinize for sales violations this year. “For individual investors, products tracking these indices may be complex or unfamiliar,’’ Finra said in a Jan. 6 letter. “It remains an open question how the indices and products tracking them will behave in different market environments.’’
No one has claimed credit for coining the now ubiquitous term smart beta, which, in just two words, makes a big, market-beating promise. Among the financerati, beta means return you get simply for taking the risk of owning stocks. The much rarer alpha is extra return from spotting something that the market missed. Despite what human managers say, alpha is rare. Smart-beta enthusiasts accept that and try to better mine the returns from beta using an eclectic range of strategies, filtered for various factors and united by their set-it-and-forget-it rule books."
The use of index funds (ETFs) is growing sharply. There are now $2 trillion in assets in the US. Four fifths are alpha, they get the average market return. One fifth are 'smart beta'. There are some arguments for them. One problem with passive index funding is that the biggest companies get the biggest weightings. They are bought more just because they are large, it is circular:
"What smart beta does best is sever the link between the price of a stock and its weight in an index, says Rob Arnott, chairman and co-founder of Research Affiliates in Newport Beach, California. Arnott has become a demigod in the movement since co-authoring the 2005 paper “Fundamental Indexation.’’ Research Affiliates indexes are used by fund companies to manage $180 billion of assets. “By linking the weight to price, the more expensive something is, the bigger your holding,’’ says Arnott, who received a bachelor’s degree in economics, applied mathematics, and computer science from the University of California at Santa Barbara. That means you’re buying some stocks because other people like them, he says, not because they’re better companies. “Why on earth would you want to do that?’’ he asks."
But just because there is a problem in one approach does not mean that, by avoiding the problem, you will get a better result. Smart beta funds have yet to prove that they work. And what especially matters is how much it costs to invest in them.
Here is a graph of the ETF growth:
