The idea of “smart beta” is gaining increased acceptance, although not without some controversy. I have to confess that I really dislike the term “smart beta,” and not just because I didn’t invent it. “Alternative beta” I can live with, or “factor” indices, or “strategy” indices — but “smart” beta leaves me cold.
Which is not to say that I dislike the concept. Unlike more venerable capitalization-weighted indices, factor indices are designed to produce a particular pattern of returns, or to exploit a putative inefficiency in securities pricing. For example: the S&P 500 Low Volatility Index extracts the least volatile members of the S&P 500; it aims to produce a pattern of returns less volatile than that of the parent index, and to exploit the so-called low volatility anomaly. Like most factor indices, S&P 500 Low Vol is not capitalization-weighted (each component’s weight in the index is in inverse proportion to its volatility). For investors who find a less-volatile pattern of returns congenial, Low Vol can be a very “smart” strategy.
So why do I object to the “smart beta” label? “Smart beta” suggests that traditional cap-weighted indices are somehow less than fully smart. That may be a clever marketing hook, but it misstates the investment merits. Most active managers underperform cap-weighted indices most of the time. That means that one of the smartest things an investor can do is to use cap-weighted indices as the core of his portfolio.