Practical Applications of Smart Beta: The Good, the Bad, and the Muddy

Practical Applications Summary

In Smart Beta: The Good, the Bad, and the Muddy, in the March 2020 edition of The Journal of Portfolio Management, James White and Victor Haghani, both of Elm Partners, discuss smart beta factor investing. They debate the merits of the most common smart beta approach: selecting securities based on factors for long-only equity portfolios. They ponder whether markets harbor enough specific risk-sensitivity differences among investors and/or pricing inefficiencies to make smart beta investing worthwhile for the typical investor, after accounting for the extra fees associated with such strategies.

The authors observe that portfolios with factor exposure have generally offered higher risk-adjusted returns than market-cap-weighted indexes. But they caution that factor investing may not be all that it appears, noting that to the extent attractive returns arise from inefficiencies, these anomalies tend to dissipate over time. They suggest that if the explanation for returns is compensation for bearing undue risks, it is unlikely, though not impossible, that most investors would want to bear concentrated exposure to that risk beyond what they get by holding the market portfolio. Additionally, factor research in general is compromised by data issues such as periodic regime changes and complex relationships among data categories. With all this in mind, the authors suggest that for most investors, holding a cap-weighted portfolio is the preferred approach.