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Investing in Smart Beta

In a previous blog I touched upon factor-based investing, noting the factors of equity, size, value and profitability. I briefly mentioned “smart beta,” with a promise of more to come.

According to Investopedia, “[b]eta represents the tendency of a security's returns to respond to swings in the market.” Marketeers have taken the term “beta”, dressed it up as “smart beta” and used it as a broad term for an investment style, often factor-based investing. There is no consensus definition; a smart beta investment offering may include a combination of traditional factors along with factors newly discovered by smart people. It takes a careful read of a smart beta prospectus to understand exactly what factors are being used in a particular investment.

New factors are discovered all the time, and investors see benefit in getting in on the ground floor of new ideas. Yet under the scrutiny of rigorous peer-reviewed research, nearly all new factors fall away as neither persistent nor investable. Nobel Prize winner Eugene Fama has observed that probably only one new factor is identified every ten years that can withstand exhaustive scrutiny.

The chart at the top of the page is a trivial example of finding a pattern in a series of ten coin tosses I conducted, heads is +1 and tails is -1. It is intended to illustrate how the human mind can find patterns in random data and how dressing it up can make it appear quite scientific. When the running total of the tosses is plotted, it seems to follow a rule expressed by the formula y = x2/90 + 41x/90.

The smart beta concept is not without merit, but because it is a marketing term without a generally agreed definition, and may contain unproven ingredients, Lyon Park Advisors can’t incorporate it into its philosophy or use it in investment recommendations to clients. For a more detailed discussion of smart beta I recommend Appendix B of Larry Swedroe’s book, “Your Complete Guide to Factor-Based Investing.”

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