Indexing Pioneer Vanguard Skeptical Of Smart Beta
Vanguard revolutionized investing with its low-cost, passive indexing products. But after the TMT (tech, media, and telecom) blowup of 2000-2002, when cap-weighted indexes became overstuffed with overvalued dot-coms, critics began maligning cap-weighted index funds as “dumb beta.” The alternative, in their view, was to weight stocks according to factors other than market cap – so-called “smart beta.” Smart-beta strategies have been hailed as the “new paradigm” in passive, index-based investing. But Vanguard, the indexing pioneer, disagrees: The firm’s Don Bennyhoff, Fran Kinniry, Todd Schlanger, and Paul Chin – authors of an August 2015 white paper titled ” An Evaluation of smart beta and other rules-based active strategies ” – insist that smart-beta strategies are in fact active strategies, and that market cap is still the best basis to weight the components of an index. How Active is Smart Beta? In Vanguard’s view, smart-beta strategies should be considered “rules-based active strategies,” by definition , since their security-selection and -weighting methodologies can produce “meaningful security-level deviations” – i.e., “tracking error” – versus a broad cap-weighted index. In the August 2015 white paper, Mr. Bennyhoff and his co-authors looked at the “active share” of smart beta ETFs and index funds. “Active share” is a measure of how much an index’s holdings deviate from a cap-weighted baseline, which in this case was the Russell 3000 – an index of the 3000 largest U.S. stocks, including the mid-to large-cap Russell 1000 and the small-cap Russell 2000: Source: Vanguard. All data as of December 31, 2014. In general, the more stocks in the index or portfolio, the less the “active share.” Smart-beta ETFs and funds had “active share” that ranged from a bit less than 30% to roughly 60%, generally much more than cap-weighted indexes, but less than “traditional, actively managed equity funds.” Smart-beta strategies also had less “active share” than ETFs focused on specific risk factors like value, momentum, and size – and its exposure to these factors that provides much of smart beta’s appeal, in Vanguard’s analysis. Which Factors and When? Vanguard admits that the performance of alternatively weighted indexes has been “compelling” over time. For instance, the alternative FTSE RAFI Developed Index returned an annualized 7.2% from 2000 through 2014, with a Sharpe ratio of 0.42. The cap-weighted FTSE Developed Index, by contrast, returned just 4.2% per year with a Sharpe ratio of 0.26. This relationship holds for most regions, too. But particular risk factors fall into and out of favor, and as a result, the performance of smart-beta strategies – relative to the broad market – has deviated substantially over time. Should investors only concern themselves with certain factors, such as dividends, cash flow, book value, sales, and volatility? Or should they consider all factors, which are too numerous to list? Vanguard says market cap-weighting captures all of these factors through the market-pricing mechanism – a compelling argument. Taking the Gloves Off Near the end of the white paper, Bennyhoff et al. take off their gloves: Smart beta doesn’t represent a “new paradigm” of indexing nor a “smarter” way to invest. The strategies’ excess returns can partly – in some cases largely – be attributed to “time-varying factor exposures,” which make smart-beta strategies effectively active and not passive. “We found little evidence that such smart-beta strategies have been able to capture any security-level mispricings in a systematic and meaningful way,” the authors wrote. An index of securities is supposed to represent “the risk-and-reward attributes of a market” or segment thereof. In Vanguard’s view, market-cap-weighting isn’t broken, and therefore isn’t in need of fixing. For more information, download a pdf copy of the white paper . Jason Seagraves contributed to this article.