09/09/2015 11:57 am ET Updated Sep 09, 2016

Smart Beta: Sometimes Smart, But Not Exactly Beta

A donut with no hole, is a danish. - Ty Webb

Live your life as though your every act were to become a universal law. - I. Kant

So-called "smart beta" is having a day in the sun. Pioneered by the very smart Rob Arnott, the basic idea is: don't invest in an index weighted by market cap -- invest in one that weights according to a non-market fundamental value measure, or even equally. Smart beta funds and ETFs have grown faster than the market. I've even seen versions of this quote in a couple of places: "market cap weighting is the worst way to own a broad index." This makes me rage a little, hence this post.

Point: If you buy a market-cap-based index like the S&P, the higher the price of a stock, the higher the market cap, and the more dollar value you're supposed to own. So, the argument goes, you're going to own too much of the overpriced stocks that are going to underperform and too little of the cheap ones that are going to outperform. 'Smarter' to buy an equal-weighted index, or one weighted by earnings, or dividends or another indicator of fundamental value!

Counterpoint: On average, the S&P investor will pay the market price for value. (Jane, you ignorant slut!)

Suppose Enron is in the S&P 500, and you're an investor in an equal-weighted S&P 500 portfolio. It goes down to 0 and gets delisted. Your equal-weight index or fundamental-weight index is buying it all the way down (assuming no change in reported fundamentals). When it hits a sufficiently small price, you're going to own the whole company.

Nice public service, dedicating 1/500 of your portfolio as insurance to bailing out shareholders of any piece of s**t company that fails its way out of the index. The 'smart' part, I guess, is dedicating only 1/500 to any one disaster. But that's a bounded definition of 'smart'.

If you just buy the market weight and hold it all the way down without throwing good money after bad, that seems like it would be a little smarter.

Likewise, the equal weight investor buys a 2% position in Microsoft when it enters the index and keeps selling it all the way up, which, as it turned out, was not the best strategy. (Selling on the way up, not buying an initial market overweight position.)

You could get even 'smarter' beta, and buy a dividend- or earnings-weighted index. Buy more of the stocks with high earnings or dividend yields, less of the stocks with low earnings or dividend yield. This will overweight cheap stocks. Indeed, I've never heard an investor say they prefer to pay higher prices. We're all value investors, just some of us are willing to pay a little more for growth. An efficient market theorist might say the value premium is a liquidity premium, a small-stock premium, a 60-year-flood premium since the cheap unloved stocks are going to be out of business in a Great Depression scenario (when 20% of companies went out of business).

If earnings-weighted indexes are really just a stealth factor model, you could weight your portfolio based on the best factors you can get paid for, like low price-to-book, high return on invested capital, etc.

But at some point you have to say, sufficiently advanced smart beta is indistinguishable from active management.

And something like the equal-weighted S&P is a gimmicky hack, and in the long run, gimmicky hacks usually don't work.

Beta is the market risk-return profile. Anything that deviates from that is, by definition, seeking to outperform the market. In other words, active management. Alpha. The smarter smart beta gets, the more it looks like alpha.

'Smart' beta, by definition, is not beta.

If smart beta isn't smart, it's just beta. If it is smart, it's just alpha. It can be smart or beta, just not both at the same time.

Smart beta is really fraidy-cat alpha. It's an investor claiming to be passive while following an active strategy that is highly diversified and based on the index.

I'd rather have a guy claiming to sell me beta with a sprinkling of alpha, than a guy selling me alpha and calling it beta.

Thought experiment: Suppose, in some alternate universe, every investor sought to invested in the equal-weight index.

The market is an election. Everybody in the market 'votes.' The equal-weight investors vote. The active investors vote. The index investors apathetically say they'll go along with whatever everyone else decides.

The market cap is the current equilibrium of all those investors' strategies.

If everyone is an equal weight indexer, as soon as a stock is added to the index, the stock gets bid to the price at which its market cap gives it equal weight in the index. That doesn't seem like a rational price. Or a smart price. That seems like a dumb price.

Being an equal weight indexer violates the Kantian/Nashian categorical imperative to invest the way, in a rational world, everyone should invest. It assumes everyone else is doing it wrong, in a very naive way, and will persist in doing so.

The current market cap is what current marginal buyers and sellers think the 'right' weight in the market should be. That's the crowdsourced answer to what the company's market cap 'should' be in the typical investor's portfolio, as determined by investors of all stripes -- indexers, active investors, and 'smart beta' investors.

Those strategies' popularity are themselves determined by their own equilibrium. When you have too many active investors, the return on active investment goes down, the expenses are not worthwhile, the least successful active investors switch to passive investing.

When you have too few active investors, the returns to active investing go back up. See Stiglitz and Grossman: If a market is perfectly efficient and prices are arbitrage-free, arbitrageurs don't get paid and exit the business. If there are no arbitrageurs, prices get out of line. In general, some arbitrageurs get paid, and prices are approximately, but not perfectly efficient.

If prices get very inefficient, arbitrage capital and talent enters the market. If prices are too perfect, arbitrage capital and talent exits the market. And then maybe even a poor capital allocator like Donald Trump can beat the market.

This is worth exploring further, since some investors (astoundingly) make an argument that increased indexing and herding are bad for active investors. The argument is that markets are like a poker game, and when dumb money turns to indexing, there are fewer underperforming investors to fleece, and less divergence between good and bad stocks, good and bad strategies.

By that argument, if you were an active investor like Warren Buffett, and could pass a law forcing all other investors to abandon active management and switch to an index, would you do it? Or would you prefer not to eliminate your competition?

Another thought experiment: Let's think through what happens if active investors leave the market and people switch to indexing. Take it to the extreme, where there's one active investor left in the market.

An IPO comes out. Mr. Active Investor solely determines the IPO price. He doesn't have anyone to compete with or have anyone to trade with, since it's not yet in the index.

The IPO at some point gets added to the index. Indexers have to buy the stock. Mr. Active Investor solely determines the price at which it gets added to the index. If a company gets delisted in favor of another company, he solely determines the price which the exit takes place.

Seems like a sweet deal. Demand a big premium when a stock goes into the index, demand a steep discount when one leaves the index.

But let's ignore IPOs and individual stocks and suppose you can only trade the index.

Suppose the passive investors decide to liquidate, they need cash to fund retirement, or just turn panicky. Mr. Active Investor solely determines the prices at which he is willing to take the index portfolio off the hands of the passive investors.

Later on, suppose passive investors have cash to invest, or turn optimistic. Again, Mr. Active Investor is the only person who can sell them the index, and he can set the price and sell them at a nice markup.

Well, my point is this: If everyone indexes, in the short run it's not a stockpicker's market. Anyone who owns any stock in the index is just getting index performance.

But Mr. Active Investor can time the market and make a bid-ask market for the index, selling when it's x% above his estimate of fair value, and buying when it's x% below fair value.

The indexers are all going to match the performance of the index every single day. And yet, Mr. Active Investor is going to crush them. Because he's always buying low and selling high. In a sense, he's going to perfectly time the market by determining what price he's willing to buy and sell at.

The more herding, the greater the volatility over time, and the more Mr. Active Investor crushes the herd.

Getting past that important aside, and back to our original point, I haven't seen any 'smart beta' fund or ETF that significantly outperforms, after fees, transaction costs, and taxes, including Rob Arnott's PRF. None of them have gotten really big or done really well over the long haul. The most popular 'smart beta' funds seem awfully niche or gimmicky.

I could see a place for some 'smart beta' funds or ETFs to fill a role in a portfolio, such as the Russell 'value' or 'growth' to boost those factors, especially when one style or the other is unusually out of favor. As long as you're aware of the liquidity issues and other potential pitfalls of ETFs, which didn't cover themselves with glory amid the recent volatility.

When someone badmouths plain-vanilla market cap passive investing, hold onto your wallet.

The dumbest way to hold a broad index isn't a market cap weighted index. It's something that pretends to be active management, or is poor active management, and charges high fees. 'Smart beta' is just a marketing gimmick for systematic active management.

As the great man might have said, investing is a dark ocean without shores or lighthouse, strewn with many a wreck... and out of the crooked timber of investment managers, no straight thing was ever made.