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The term smart beta is alleged to have been invented by the consulting firm Willis Towers Watson in 2006. (Although I have no reason to doubt that claim, neither have I been able to find the original source.)
The “smart” portion of the label you can understand: it’s advertising. Explaining “beta” takes a bit more work. Sixty years ago, Nobel laureate William Sharpe theorized that stock returns came from two causes, which he called beta and alpha. Beta measures the level of a portfolio\s exposure to the overall stock market. (For this discussion, we can ignore alpha.)
Over time, practitioners turned Sharpe’s mathematical definition of beta into slang. Beta no longer signified merely the result of a calculation. The word also could be applied loosely, to indicate the performance of an asset class. By this usage, if US equities gained 8%, and long US Treasuries returned 5%, the betas of those two investments would be 8% and 5%, respectively.
Smart Beta Out, Strategic Beta In
We can now understand the meaning of smart beta. The term describes a portfolio with returns that come solely from its beta exposure(s)—which, and I truly do regret the additional jargon, are sometimes called “factors.” Smart-beta funds are passively managed, omitting the ongoing decisions of portfolio managers. However, unlike rival index funds, which represent an entire marketplace, smart-beta funds pick their spots. They seek more than to duplicate reality. They expect to improve upon it, because they are “smart.”
I know this all sounds vague. Three illustrations should clear the haze. Smart-beta investment examples include passively run funds that hold stocks that:
• pay large dividends;
• have high recent stock market gains; or
• are issued by companies that combine above-average earnings with below-average debts.
That is: they use mechanical rules to construct portfolios that are marketed as being superior to standard indexes.
Of course, branding a fund as “smart” does not make it so. (If only investing was that easy!) For that reason, many researchers have rejected the smart-beta label, Morningstar among them. Its official term is strategic beta. Consequently, I will now switch to that nomenclature.
Jack Bogle’s Verdict on Smart Beta
When I first wrote about strategic-beta funds, I was supportive, stating that they were “here to stay.” Most fund inventions fail, as new offerings tend to be extravagantly priced. In addition, they employ untested strategies that often surprise their shareholders. But as strategic-beta funds were passively run, they would avoid those problems by being cheap and performing predictably.
With those outlooks, I was correct. The median annual expense ratio for today’s strategic-beta funds is a modest 0.38%. And their portfolios hold no secrets. Unlike their actively managed rivals, strategic-beta funds do not “drift” from their investment approaches. Consequently, they proved very much here to stay, as they now control $2.3 trillion (£1.7 trillion) in fund assets.
What I overlooked, though, was whether smart-beta investors would choose well. After all, smart-beta funds are a cousin of sector funds, in holding one segment of a marketplace. And sector fund shareholders have fared poorly, owing to their habit of buying high and selling low. They chase performance.
Such was Jack Bogle’s concern. In the same year that my relatively sunny article appeared, Bogle panned strategic-beta funds: “sometimes [investors] will pick the right factor, sometimes they will pick the wrong factor, but to the extent that investors pick the hot factor, they almost assuredly will be wrong.” Such funds, he concluded, were ”stupid.”
What Are Investors Buying?
Let’s see which has proved more accurate: Rekenthaler’s optimism or Bogle’s pessimism. (Being on the other side of Bogle is a troubling position.) Our starting point will be the largest strategic-beta funds from 10 years ago. Did 2014’s strategic-beta shareholders chase past returns, or were they investing strategically by looking forward? In either case, how did their funds perform?
The good news: they have invested rationally. Among the largest 10 strategic-beta funds in September 2014, all of which held US equities, 51% of shareholder assets were in value-style funds, 38% in growth funds, and 9% in blend funds. On average, those funds had slightly trailed the return for Vanguard Total Stock Market Index VTSAX over the previous decade. In short, the first generation of strategic-beta investors did not chase performance.
The bad news is that they did not profit from their decisions. Over the next 10 years, September 2014 through August 2024, the asset-weighted return for those 10 funds was 11.50%, as opposed to 12.31% for Vanguard Total Stock Market Index. To be sure, this back-of-the-envelope calculation does not tell the full story, as moneys flowed into and out of those funds, but it does suggest that smart-beta investors would have profited by following Bogle’s advice.
The allocations made by strategic-beta investors are similar today. Of the current 10-largest list, 49% of assets are in value funds, 40% in growth funds, and 11% in blend funds. Those figures are almost identical to 2014′s totals, indicating that once again, strategic-beta fund investors are well diversified.
But the winds are shifting. Among this year’s 10 bestselling strategic-beta offerings, funds that have outgained Vanguard Total Stock Market Index over the past five years have received 80% of net new sales. Five of those 10 funds openly market themselves as growth portfolios, while two more favor high-quality companies that trade like growth stocks. That development, it must be confessed, evokes Bogle’s concern about “hot factors.” It seems that after many years of holding out, strategic-beta investors have decided if they can’t beat growth funds, they should join them.
Why Bogle’s Warning is Relevant
Jack Bogle has not yet made me look foolish—not on this topic, anyway. During most of the short history of strategic-beta funds, their shareholders have spread their bets rather than herd into recent winners. True, most have not benefited from those decisions. As Bogle predicted, strategic-beta shareholders would have earned more money had they attempted to be less clever and instead simply bought a standard US equity index fund.
However, the current sales charts hint that Bogle’s warning is now relevant. Not only are growth funds dominating inflows, but stalwart Vanguard Value Index VVIAX, which for many years now has been the second-largest strategic-beta fund, has fallen off the bestseller list entirely. Such behavior is reminiscent of sector funds—and that is not a compliment.
John Rekenthaler is vice president of investment research at Morningstar. He does not not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies. The opinions expressed here are the author’s Morningstar values diversity of thought and publishes a broad range of viewpoints.
