Live your life as though your every act were to become a universal law. – I. Kant
A donut with no hole, is a danish. – Ty Webb
Random end-of-summer ramblings. All musings must go!
So-called “smart beta” is having a day in the sun. Basic idea: don’t invest in an index weighted by market cap — invest in one that weights equally, or according to a non-market value measure.
Point: If you buy a market-cap-based index like the S&P, the higher the price of the stock, the higher the market cap, and the more dollar value you’re supposed to own. So, the argument goes, you’re going to own too much of the overpriced stocks that are going to underperform and too little of the cheap ones that are going to outperform. ‘Smarter’ to buy an equal-weighted index!
Counterpoint: This is a silly argument, since it’s equally true that on average the S&P investor will pay the market price for value. (Jane, you ignorant slut!)
Suppose Enron is in the S&P 500, and you’re an investor in an equal-weighted S&P 500 portfolio. It goes down to 0 and gets delisted. Your equal-weight index is buying it all the way down. When it hits a sufficiently small price, you’re going to own the whole company.
Nice public service, dedicating 1/500 of your portfolio as insurance to bailing out shareholders of any s**t company that fails its way out of the index. The ‘smart’ part, I guess, is dedicating only 1/500 to any one disaster. But that’s a bounded definition of ‘smart’.
If you buy the market weight and just hold it all the way down without throwing good money after bad, that seems like it would be a little smarter.
Likewise, the equal weight investor buys a 2% position in Microsoft when it enters the index and keeps selling it all the way up, which, it turned out, was not the best strategy. (Selling on the way up, not buying an initial market overweight position.)
You could get even ‘smarter’ beta, and buy a dividend- or earnings-weighted index. Buy more of the stocks with high earnings or dividend yields, less of the stocks with low earnings or dividend yield. This will overweight cheap stocks. Indeed, I’ve never heard an investor say they prefer to pay higher prices. (In that sense we’re all value investors, just some of us are willing to pay a little more for growth.) An efficient market theorist might say the value premium is a liquidity premium, a small-stock premium, a 60-year-flood premium since the cheap unloved stocks are going to be out of business in a Great Depression scenario (when 20% of companies went out of business).
If earnings-weighted indexes are really just a stealth factor model, you could weight your portfolio based on the best factors you can get paid for, like low price-to-book, high return on invested capital, etc.
But at some point you have to say, sufficiently advanced smart beta is indistinguishable from active management.
And something like the equal-weighted S&P is a gimmicky hack, and in the long run, gimmicky hacks usually don’t work.
Beta is the market risk-return profile. Anything that deviates from that is, by definition, seeking to outperform the market. In other words, active management. Alpha. The smarter smart beta gets, the more alpha.
‘Smart’ beta, by definition, is not beta.
If smart beta isn’t smart, it’s just beta. If it is smart, it’s just alpha. It can be smart or beta, just not both at the same time.
Smart beta is really fraidy-cat alpha. It’s an investor claiming to be passive while following an active strategy that is highly diversified and based on the index.
I’d rather have a guy claiming to sell me beta with a sprinkling of alpha, than a guy selling me alpha and calling it beta.
Thought experiment: Suppose, in some alternate universe, every investor sought to invested in the equal-weight index.
The market is an election. Everybody in the market ‘votes.’ The equal-weight investors vote. The active investors vote. The index investors apathetically say they’ll go along with whatever everyone else decides.
The market cap is, in a sense, the current equilibrium of all those investors’ strategies.
If everyone is an equal weight indexer, as soon as a stock is added to the index, the stock gets bid to the price at which its market cap gives it equal weight in the index. That doesn’t seem like a rational price. Or a smart price. That seems like a dumb price.
Being an equal weight indexer violates the Kantian/Nashian categorical imperative to invest the way, in a rational world, everyone would invest. It assumes everyone else is doing it wrong, in a very naive way, and will persist in doing so.
The current market cap is what current marginal buyers and sellers think the ‘right’ weight in the market should be. That’s the crowdsourced answer to what the company’s market cap ‘should’ be in the typical investor’s portfolio, as determined by investors of all stripes — indexers, active investors, and ‘smart beta’ investors.
Those strategies’ popularity are themselves determined by their own equilibrium. When you have too many active investors, the return on active investment goes down, the expenses are not worthwhile, the least successful active investors switch to passive investing.
When you have too few active investors, the returns to active investing go back up. See Stiglitz and Grossman: If a market is perfectly efficient and prices are arbitrage-free, arbitrageurs don’t get paid and exit the business. If there are no arbitrageurs, prices get out of line. In general, there will be a situation where some arbitrageurs get paid, and prices are approximately, but not perfectly efficient. If prices get very inefficient, arbitrage capital and talent enters the market. If prices are too perfect, arbitrage capital and talent exits the market.
This is worth exploring further, since some investors (astoundingly) make an argument that increased indexing and herding is bad for active investors. The argument is that markets are like a poker game, and when dumb money turns to indexing, there are fewer underperforming investors to fleece, and less divergence between good and bad stocks, good and bad strategies.
By that argument, if you were an active investor like Warren Buffett, and could pass a law forcing all other investors to abandon active management and switch to an index, would you do it? Or would you prefer not to eliminate your competition?
Another thought experiment: Consider what happens if active investors leave the market and people switch to indexing. Take it to the extreme, where there’s one active investor left in the market.
An IPO comes out. Mr. Active Investor solely determines the IPO price. He doesn’t have anyone to compete with or have anyone to trade with, since it’s not yet in the index.
The IPO at some point gets added to the index. Indexers have to buy the stock. Mr. Active Investor solely determines the price at which it gets added to the index. If a company gets delisted in favor of another company, he solely determines the price which the exit takes place.
Seems like a sweet deal. Demand a big premium when a stock goes into the index, demand a steep discount when one leaves the index.
Suppose the passive investors decide to liquidate, they need cash to fund retirement, or just turn bearish. Mr. Active Investor solely determines the prices at which he is willing to take the index portfolio off the hands of the passive investors.
Later on, suppose passive investors have cash to invest, or turn bullish. Again, Mr. Active Investor is the only person who can sell them the index, and he can set the price and sell them at a nice markup.
Well, my point is this. If everyone indexes, in the short run it’s not a stockpicker’s market. Anyone who owns any stock in the index is just getting index performance.
But Mr. Active Investor can time the market and make a bid-ask market for the index, selling when it’s x% above his estimate of fair value, and buying when it’s x% below fair value.
The indexers are all going to match the performance of the index every single day. And yet, Mr. Active Investor is going to crush them. Because he’s always buying low and selling high. In a sense, he’s going to perfectly time the market by determining what price he’s willing to buy and sell at.
The more herding, the greater the volatility over time, and the more Mr. Active Investor crushes the herd.
As the great man might have said, investing is a dark ocean without shores or lighthouse, strewn with many a wreck… and out of the crooked timber of investors, no straight thing was ever made.