Gallery:Step 2|Step 2: Nobel Laureates

Two Nobel Laureates—Two Views of Smart Beta

Gallery:Step 2|Step 2: Nobel Laureates

Smart beta appears to be all the rage in the investment world right now. According to this Financial Times article citing Morningstar data, there were 673 smart beta exchange-traded products representing just under $400 billion as of 6/30/2014. In one of our recent articles, we stated our agreement with Burton Malkiel when he said, “Smart beta portfolios are more a testament to smart marketing rather than smart investing.” Since Professor Malkiel has not yet been awarded a Nobel Prize (although we certainly hope he will be), the above title does not refer to him but rather to Robert Shiller (2013) and William Sharpe (1990).

In our daily perusal of the financial press, we saw this Institutional Investor article discussing how Professor Shiller had teamed up with DoubleLine to create a smart beta fund based on sector rotation using Shiller’s cyclically-adjusted price-to-earnings (CAPE) ratio. This fund is rather complex, with a core portfolio of bonds on top of which are placed index swaps to gain exposure to sectors that are deemed to be undervalued while controlling for negative momentum. The fund began operations just after the 2013 Nobel Prize was announced, so the timing was highly fortuitous, but since it has only been around for about 13 months, there is no meaningful returns analysis that can be performed on it.

Since much of Shiller’s work focuses on behavioral-based explanations of returns, he would probably consider the value tilt of his DoubleLine fund to be a method of profiting from the suboptimal behavior of other investors rather than a risk premium as compensation for investing in distressed companies.

William Sharpe won his Nobel Prize for the Capital Asset Pricing Model in which he introduced beta as a measure of a security’s or portfolio’s sensitivity to the market. Here is what he had to say in a recent issue1 of the Financial Analysts Journal:

 “So, when I hear ‘smart beta,’ it makes me sick. By definition, if you’re talking about doing better than an appropriate benchmark, then it’s important that you specify what the benchmark is. If the benchmark is not the market portfolio, that’s fine. You can say, ‘I’m going to beat the market more often than not.’ We used to call that ‘alpha.’ Or if you say, ‘I’m going to beat the market by tilting toward small stocks, away from the market proportions,’ then that’s fine as well. That is a factor bet or a factor tilt.”

To summarize Sharpe’s view, beta is beta—there is no smart or dumb. What the investment industry now considers to be “smart beta” is just factor tilting, and there is nothing wrong with that. We agree.  

 

1Sharpe, William F., and Robert Litterman (2014). “Past, Present, and Future Financial Thinking.” Financial Analysts Journal, Vol. 70, No. 6 (November/December): 16-22.