4 February 2023
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Josh Barrickman
Head of Fixed Income Indexing Americas
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Why Smart Beta Can’t Win the Indexing Race
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Whenever I explain indexing to friends and family, I always fall back on my favorite analogy: the car race.Imagine a race where one car represents the market and is set up in a certain way—with tires, fuel, suspension, and so on—all meeting precise specifications.The indexer is in another car, and its job is to finish in a dead heat with the market car. Naturally the indexer will tune its car—or portfolio—to match the specs of the market car as closely as possible. All else being equal, this should result in the desired outcome. To extend the analogy further, active managers would tweak their cars to try to give themselves an edge in winning the race against the market car. That’s straightforward, right?
The promise of “smart beta” or“fundamental indexing” has been getting a good deal of attention as of late,and has generated questions from clients. I would say that the clients I speak with generally approach the topic with a healthy amount of skepticism, but are intrigued nonetheless.

I can sum up my thinking on the matter very concisely: Smart beta isn’t beta, and fundamental indexing isn’t indexing. That’s not to say that it’s bad or doesn’t have its place, it just shouldn’t be confused with beta or indexing. It’s something else.

 When you look at what smart beta offers, it’s pretty compelling—systematic overweights or underweights to risk factors that have been shown historically to produce higher returns, less volatility, or both. If we accept at face value that smart beta is able to deliver what it promises (more on that later)—you would have a great product—just not an index product. Indexing by definition is owning the market.Fundamental indexing is betting against the market. 

It seems obvious to me (and hopefully convinces you, too) that smart beta belongs in the active bucket. Infact, it’s hard to make an argument as to why smart beta should be considered an index product when the issue is black and white. It either follows a market-cap weighted index or it doesn’t.

So why the confusion? Well, in my mind the confusion is deliberate, and it boils down to two things. First,indexing is popular. The share of passively managed assets has grown dramatically over the past few years in part because of lackluster active performance and the continued adoption of ETFs. Given that backdrop, it’s an attractive time to position products within the ethos of indexing. Secondly,given the presence of several large established incumbents, investment providers may be unwilling or unable to compete in the traditional index space.

As with anything, it’s important to understand motivation. When you combine the popularity of indexing as a concept with the competitiveness of the market for traditional index products,then the motivation becomes clear why these active products would be sold as indexed. If investment providers can sell the idea that smart beta is indexing,then not only can they compete for the core of investors’ portfolios, they can also receive a premium for their services in the form of higher expense ratios.

Let’s transition to the specifics of what smart beta offers, especially in the fixed income market. Proponents of smart beta will argue that market-cap weighted indexes are flawed because they invest more in the bonds of companies or countries that have higher debt levels or higher prices. The solution, they argue, is to weight the constituents of an index on fundamental characteristics such as leverage or interest coverage instead of market cap.

Unfortunately the premise that underlies this argument is flawed, which is that the market arbitrarily allows companies to issue debt without demanding appropriate compensation for risk,and that changes in an issuer’s bond price aren’t directly related to that issuer’s creditworthiness. In other words, the market isn’t efficient. While some folks would reject the notion that the market isn’t efficient, let’s assume for a moment that’s the case. Then some active managers might have an informational edge and might be able to produce greater outperformance. Nevertheless, the average active manager would still underperform the market because of costs.Costs will always be a hurdle for active to get over.

Now let’s examine what smart-beta is offering: not only do you have an active product, but you have an active product that’s locked into a certain style without the ability to toggle between risk factors. So in other words, you have an active product minus some of the flexibility; that is, the skill that talented active managers offer in terms of trading strategies and specific positions.

Going back to the car race analogy, indexing can only be defined as tracking a market-cap weighted index.Therefore, the smart beta car is nothing but an active car without a driver.Fundamental indexing may have a place—it could work for an investor looking to bet on a certain risk factor in a transparent way—it’s just important to understand what this investment strategy is and, more importantly, what it isn’t.

Josh Barrickman, Senior Portfolio Manager and Head of Fixed Income Indexing Americas.

© 2014 The Vanguard Group, Inc.All rights reserved. Used with permission. 

 

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