Bill Sharpe gave us the Sharpe Ratio to help determine whether an active investment manager is “beating” the market after adjusting for the risk that the manager assumed. Sharpe is from the Efficient Market school of academia, which believes that markets are too efficient to beat consistently. He is also the founder of an online investment adviser.
At this month’s CFA Institute Annual Conference in Seattle, Sharpe said that Smart Beta made him sick because it implied that index investors had to be “dumb beta.” Sharpe believes the so-called dumb beta investors would eventually gravitate to Smart Beta strategies because no one is that dumb for long, and then the advantages of Smart Beta would simply melt away into average beta.
As regular readers know, Fama and French (F&F), and later Lakonishok et al. (LSV) (See F&F and LSV tab above) demonstrated as early as 1992 that two factors consistently resulted in outperformance in the long run: Value and Small Cap. It is largely these two factors that put the “smart” in “Smart Beta.” F&F and LSV were not the first academics to publish papers on the value and small-cap factors, but they certainly popularized the factors in academia. Before these academics came along, we had research from practitioners Ben Graham from the 1930s through the 1970s; Warren Buffett from the 1950s to today; and Seth Klarman from the 1980s to today; that demonstrated that value strategies consistently outperform the market in the long run.
Since F&F and LSV published their research in the 1990s, there has been an overwhelming amount of academic research that demonstrates that value strategies outperform. Most of that research proves that value outperforms for reasons that are not related to risk, therefore value has consistently delivered alpha in the long run.
Most Smart Beta strategies are nothing more than systematic ways for managers to capture some of the factors that are known to deliver this alpha in the long run. The adoption of this approach in a more systematic and passive way somewhat proves Sharpe’s theory that no one stays that dumb for long. However, value and small-cap strategies outperform over long periods not necessarily because value and small-cap investors are smarter than everyone else, but because behavioral flaws and institutional constraints do not permit EVERYONE to FULLY capture the alpha in value and small cap. I remind you that it did take over 150 years for Smart Beta to be born.
Only small investors with contrarian streaks (see my future post on Investor DNA) can fully exploit these factors. Even Smart Beta strategies will fail to fully exploit these factors because of the amount of capital that Smart Beta will need to invest. Much of that capital will have to be allocated to large cap firms, but most of the alpha in these factors is found in relatively unknown and un-followed small-cap firms.
So, my answer to Sharpe’s queasiness is this: Smart Beta is just a label. Would he have taken less umbrage if that label were “Behavioral Beta” or “Factor-Focused Beta?”