Asset AllocationJanuary 3, 2016

Morningstar: Smart Beta Is Active Management

Investors should determine smart beta’s source of outperformance, how long the source persists, and how to implement the beta, a columnist has argued.

Reported by Featured Author

Smart beta is active management and investors should evaluate it as such before investing, according to Morningstar’s Vice President of Research John Rekenthaler.

Even though smart beta is typically presented in exchange-traded funds (ETF) or other structures “that mimic indexes,” they are not passive strategies, the columnist wrote.

“They implement active decisions, with the promise of delivering outperformance, and should be evaluated accordingly,” he said.

Rekenthaler argued smart beta strategies must be supported by reason—“some credible explanation why that particular beta is superior.” The justification for holding value stocks, for example, is that they can earn higher returns in exchange for higher risk.

Rekenthaler pointed out that “everything flows from why. If there is no satisfactory answer to that question, then those pretty back-tested numbers likely came by accident.”

“The data were mined until they yielded something shiny and yellow—but fool’s gold it was,” he added.

“They implement active decisions, with the promise of delivering outperformance, and should be evaluated accordingly.”Similar to other active strategies, only economic or behavioral justification would support smart beta funds’ backtested returns. Rekenthaler pointed out that these justifications were “not static,” as correlations and resulting premiums change over time.

Behavioral biases that serve as sources of extra performance for smart beta, on the other hand, are less likely to change, the column said—and this could also undermine smart beta strategies.

“Because of increased investor awareness, they could become so popular that their behavioral support no longer matters,” Rekenthaler wrote.

For example, if investors already know that value stocks “offer a free lunch” by outperforming growth stocks, are less volatile, and their ETFs see more inflows than growth-style funds, their prices may be pushed so high that value investing no longer delivers future outperformance.

Lastly, Rekenthaler pointed out that investors must also decide how to implement a smart beta strategy and identify a particular factor, much like active investments. Even if an investor choses a ‘passive’ smart beta ETF, he argued that one must make an active and “real and important decision” regarding factors and implementation.

“By no means will one value-stock ETF match the performance of another, even if they sound alike and fish in the same investment pond,” the columnist wrote. “The same holds for other strategic betas as well.”