Whether the markets are rising or falling, investors are always looking for ways to beat the odds. Everyone wants to feel like their investment strategy is as solid as possible, regardless of market conditions. Such a strategy is a smart beta investment approach.

What is Smart Beta Investing?

About fifteen years ago, a professional services firm called Towers Watson coined the term “smart beta.” However, the term was around long before that, dating back to the 1970s. It took more than 30 years for the first beta ETF to launch in 2003. Since then, smart beta fund managers have tweaked and refined strategies and their investment methodologies.

According to ETF.com, “with 1,209 ETFs traded in the US markets, Smart Beta ETFs have total assets under management of $1,574.77 billion. The largest Smart Beta ETF is Vanguard Value ETF VTV with $101.00 billion in assets.

Smart beta refers to enhanced indexing strategies that aim to exploit certain performance factors in an attempt to outperform a benchmark index. Smart beta investing is essentially a combination of active and passive investing. Taking the best of both for the most optimal result.

Smart beta aims to give investors an edge by reducing risk, increasing diversification and reducing overall cost. All this while creating the most optimal portfolio possible. Efficiency and value are the two main points of interest. At least one or more of these factors are wrapped in custom indexes or ETFs. However, as IU Einstein and Quant Expert Nicholas Vardy explains…often the moment a smart beta strategy is introduced through an ETF, it stops working.

The fundamental problem

Just last month, Nicholas Vardy wrote an article about Freedom Through Wealth called “The Fundamental Problem with Smart Beta ETFs.” In it he explains some of the less-noticed issues with the investment approach.

“These Smart beta ETFs bet on factors such as momentum or the aristocrats of dividends to beat the market. Each of these strategies is supported by research conducted at the world’s leading investment firms and business schools. However, I have been disappointed by the real-world performance of smart beta ETFs. It seems that the moment a strategy is introduced through an ETF, it stops working.”

Nicholas goes on to refer to an essay by Stanford Medicine Professor John Ioannidis called “Why the Most Published Research Findings Are False.” In it, Ioannidis reveals how “results published in many medical research papers cannot be replicated by other researchers.Ioannidis’ financial counterpart, Campbell Harvey, professor of finance at Duke University, estimates that “at least half of the 400 “market beating” strategies identified in major financial journals over the past few years are worthless. He challenges academics to take any so-called winning strategy and ask a diverse group of researchers to replicate it. And the odds are about 50-50 that they can’t. Even worse, Harvey argues that his academic colleagues are in complete denial of the problem.

Data manipulation

Vardy then goes on to talk about how smart beta data can be manipulated…

“In statistics, a p-value represents the probability that a finding is statistically significant – attributed to an actual factor rather than pure chance. For example, it will show if a particular drug works or if value stocks outperform over time.

The problem is this: Researchers distort the data – overtly or unconsciously. They can choose the measurements used or adjust the time period studied to obtain a statistically significant result. We can blame the “system” for this problem.

Young finance professors can publish a paper with a compelling finding in a prestigious journal—and they just might get tenure. As a result, investment strategies that look great on paper often fall short in the real world.”

Smart Beta Investing – Summarized

As Nicholas and others have pointed out, many of the strategies surrounding smart beta investing are quite impressive. However, now that the term smart beta has been around for more than a few decades, it has lost some of its magic. The real-world performance of smart beta ETFs has often missed the mark.

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