“The problem is that they are practically tough to access and, more important, can disappear for years at a time,” PERSI’s Maynard argues. “‘Smart beta’ is often ‘beta that smarts’, meaning ‘hurts’ for quite a while. The illiquidity premium has not been there for the last five years, for example. So, if you can stick with it through thick and thin for 10 years at a time, then it is worth it – we have some of them. But it certainly isn’t an approach that will give you consistently better returns.”
Ultimately, the dominance of cap-weighted benchmarks, particularly in the equity space, reinforces their usefulness for investors as benchmarks for both measurement and investment, regardless of whether they are flawed. The practicality and ease of trading cap-weighted benchmarks makes them cheaper, more liquid and more transparent, which is difficult for investors to argue with.
“Building tradeable instruments on smart beta indexes can be quite difficult,” Redington’s Schulze says. “Investors can very easily buy futures and options, for example, on widely used capital-weighted benchmarks. The costs for doing so on alternative indexes would be significantly higher, assuming that such instruments are available, and investors could quickly run into practical problems.
“I’m not sure many investors would therefore come down on the side of a theoretically more sensible index,” he argues. Maynard, for one, remains a big believer in market capitalisation-weighted indexes regardless of whether or not they truly are on the efficiency frontier.
“In a world of complex, adaptive systems, they represent the safest long-term and market approach,” he concludes. “Whether they give you the ‘best’ return is actually secondary.”
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