Kudos to the marketing geniuses of the investment management industry.

John Galbraith once said “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” Was he a clever man and was he right!

Let’s leave the instability issue alone (we have enough of it elsewhere) and focus on reinventing the wheel. You’d think Galbraith’s statement surely would no longer apply today, after a few more decades of intense market studies and theoretical developments. You’d think wrong: pushed by the never-ending need to keep the excitement up, the investment management industry recently gave us a concoction of portfolio strategies called “smart beta” (“SB”).

This is a very savvy marketing ploy. The intriguing aspect of SB is that investors now have more affordable and tradeable investment vehicles for their portfolios. The insidious aspect of SB is that there is really nothing new under the sun: these investment vehicles consist of well-known active management strategies dropped into an ETF envelope. Put differently, SB vehicles are a way to give you a discount on management fees without admitting it.

There are no smart or dumb betas in the real world. Beta is a component of the Capital Asset Pricing Model equation and it’s often used as synonymous for “market risk”; more generically it represents the slope of a straight line. That’s it. You cannot attribute to beta the capacity to think or to cuddle next to you any more than you could to a frying pan or to an artichoke.

How did we come to give mental attributes to a coefficient? The popular acceptance and tremendous growth of passive investments has wreaked havoc with many large financial supermarkets and so it’s no surprise they felt compelled to do something to stop hemorrhaging funds. They came up with the idea of affixing the label “dumb” on the standard beta provided by ETFs and simultaneously the label “smart” on their new creations, which then get transfigured into “passive” by association. In practice this translates into substituting active investment management processes for passive replication formulas of capitalization-weighted indices. Interestingly this implicit rejection of traditional benchmarks does not appear to have unduly influenced the practice of large institutional portfolios which continue to rely on standard market-cap indices.

By camouflaging standard active investment processes into ETF-like shells, managers claim to have found the new elixir for making money when all they’ve done is rearrange the boxes and change the label. Funds which invest in value, high-dividend, momentum, high-sales growth, low price-to-book or other fundamental factors have existed for decades; they just weren’t call “smart” anything. The additional stroke of marketing genius is to make SB “feel” like index-replicators, so that investors think they are buying passive while actually they are doing the opposite. Some managers, like WisdomTree, go as far as defining their own indices on which to base their exchange-traded products.

To be sure, there is nothing necessarily bad in any of this. As always, just make sure you understand what you are investing in.  

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