The Mystery of Smart-Beta, Explained

t F and we called the plane vanilla side. But this is up from nothing ten years ago, so it is a it's growing faster on a percentage basis than e t F as a whole, and it's a really interesting dynamic area. This is where a lot of the innovation and new products are being launched. So how are we supposed to think about this thing called smart beta. Well, it's very it can be confusing a lot of times. People think it sounds like something you get at the

g n C store. Yeah, I mean right, I know, you're like a way container little double chocolate smart beta. It's definitely jargon e um and it's got a buzzword type feel to it. But um, you know. Essentially, a lot of people will give you different definitions of it. To me, you know, the metaphor I use is the way people describe different religions, right they there's this thing that they say, it's like a bunch of people touching an elephant in a dark room, in the way different

religions describing God. It's the same thing, but it's just being Uh, they're feeling a different part of it, but ultimately it's the same thing to me. Smarting Right now, what is that I'm in a dark room? You don't want to know. No, let's say you're touching the trunk. Somebody else is touching the side. My point is that

smart beata kind of can mean different things to different people. Uh, it's controversial, and I think that a lot of people instead of thinking you need to like capture it and be done with understanding it in two seconds, I think you need to just accept that it's a little bit of a mystery to some people. There's a complexity to

it and there's differing opinions. As long as you embrace that and sort of go into this conversation we're about to have knowing that you're gonna understand a little more. I think that's the way to go. You gotta lower the bar on this because you can't really just get it done in like two or three sentences. If I had to do it in one sentence, what would you how would you describe it? I would say smart Beta is trying to take Peter Lynch's brain and put it

into our two D two's think. In other words, you're trying to take the best of active management, but putting it into a rules based index that an e t F track. So it's basically a conversion of active and trying to make it better and more efficient and cheaper and deliver it in a better structure. This week, Gun Trillion, the Mystery of smart Beta. Okay, Eric, we've got some guests. This is really important because I think every one of these guests, including you and me, we'll have a different

perspective on smart Beta. So we're all sort of touching the elephant in your dark room, your creepy dark room filled with an elephant and us. Yeah, it's almost akin to when you go to a conference. So an ETF conferences, there's a panel, you tend to have people from different lenses. So we're trying to sort of capture that so that you can get all of the viewpoints and then you can sort of come up with your own sort of view on it. One of them is remote, so he's

in his own dark room touching a different elephant. Near case are a columnst with Bloomberg gad fly high near Hello, he's in d C. Joining us in the booth is Tom Seraphagus, who is a colleague of yours at Bloomberg Intelligence, where he's an et F analyst. Also came from Oppenheimer before he was at Bloomberg uh and has some experience with smart beata et F. Sah, how are you. I'm doing great, Thanks for joining. So Tom, can you help

start this discussion around what is smart beata. Let's definance so that you know, before people get in the deep to the pool with us, we have an understanding of what we're talking about. Yeah. Sure. And so before I joined here, I was at on the other side of the table, so on the issue side. And you have to remember that a lot of these active shops have a tremendous amount of resources, right They've got portfolio managers

and analysts. So I think in a very brief way, what they were trying to do is take the mind of the portfolio manager Peter Rearle and sure someone else saying, Hey, when you're picking stocks, what are things you're looking at? How are you running your screens? What are you looking at? Let's take your approach, put it, write it down, put it in an index, and launch an e t F over it. So, um, you know, the the definition of smart data. It's not so clear, right, it's a very

gray area. But it's really trying to take a lot of these approaches, democratize it, put in e TF and make it available to the masses as a product, as a problem, buy off the shelf, right, how do you think about it? I think those are both good. Both Eric and Tom's definitions I think are both good. I'll just try to simplify it even further because I think it's really important to convey to to investors that this is actually very simple in concept. All this is is

traditional active management. All that all the strategies that they've always loved and have been used for decades by every active manager ever. Value you know, buying cheaper companies, buying you know, high growth companies, buying smaller companies, whatever the strategy that you like is effectively giving it to a computer and letting a computer run it. That's really all

it is. And the reason that's important to convey is the the the act of taking it away from the from the human and giving it to the computer gives the investor several advantages that are really important. One, it makes it a lot cheaper because you can you know, the computer doesn't cost as much as the human. That's the first thing that's you know, that's a good thing. The second thing is they're more transparent because you've turned it over to a computer. You've had to write rules

about how this thing will look. And investors can read these rules and they can see exactly what they're buying, So that's useful to And the other thing is that it allows them. It allows us to to um to fine tune how we think about these various styles. So for example, me and you, we might both like value, right, but you might like it more than me, So I can write a computer program for you that gives you more value and less value for me, and so on.

And these are things that are more difficult to do with human beings. So that's all it is. That sounds simple. Let me add in here to dovetail to my original definition and just go and how the term came about, because this probably will help. A consulting firm named Towers Watson is who coined the phrase smart beta, and this is exactly how they defined it in their literature in your two thousand. Smart beta is simply about trying to identify good investment ideas that can be structured better. So

think about it. What do people not like about an active mutual fund? Their high cost uh they have the manager could be emotional and make decisions based on the current trends, and they have distribute capital gains regardless of whether you if even if you stayed invested, you've got tax bill. Now, if you take that active mutual fund strategy and you put it into a rules based index, you essentially eliminate the emotion, right because it's gonna rebalance

at least us said it's a robot. You're gonna lower the feet because there's less overhead. And the ETF structure so usually like a third as cheap as or a third as expensive as an active mutual fund, and they're et f s are very tax efficients. You can have some decent turnover inside the fund, and yet no capital gains get distributed, so you eliminate three of the baggage of the active mutual fund when you cross it over. So,

in a way, Towers Watson definition is true. It's just been mutated over the years and piss people off because they think that it means smart means better, and it's not necessarily better. It's better, a better way to deliver something, not you're gonna definitely outperform unless we're clear. There's also different names for smart beta. It's not like smart beta is the only one, right Tom, Like, what other what other terms can mean smart beta? Yeah, I mean there's

a lot of terminology that's been thrown out. People call it strategic beta, tarnative beta, active beta, um, you know. And a lot of people will get caught on, get caught up in the semantics because they think that, oh, if it's not smart beta, it's dumb beta. Right. It's not. It's not so binary that it's just one or the other. So a lot of people send they get caught up in the semantics and kind of forget, like, what is the bigger theme here? What are these products giving you?

What are they offering you? Can you help me embrace the complicated a little bit here, because one of the main differences with smart beta is with a with a normal ETF the most popular ones to play vanilla ones, those are all market cap weighted, right, So help me better understand what sometimes the differences with smart beta. Right when the Towers Watson definition, they would call all that bulk beta. So there's just two bulk beta, which is market cap weighted. This I think a lot of people

just called beta. So just tell me what market cap is right like that? Right, So the SMP five hundred, the bigger the stocks market cap, the bigger the waiting, right, so as stocks get bigger, that sort the top waitings in the Sapier, Apple, Microsoft, Amazon, Right, you got it. Now, that is another way to view smart beta and how

some people do it. If you're in the index fund were world or the vanguard world and you're used to market cap weighted products which are very popular, smart beta to you seems like a mutation or a twist on the market cap waiting structure. So you could actually view smart beta from that lens and either look at it as you know, a way to try to do better than the market cap waited next, because you're gonna change the way the index works. You're gonna maybe wait by

dividends instead of market cap. You're gonna wait by size. You could wait by a collection of fundamentals. That is another way to view it. So you can see you can see smart beta from the active side or from the passive side and describe it different ways. But it sounds kind of controversial, right, Well, it is. The word smart is the controversial part. But I equated to Obamacare, right remember that what was the real name of the bill?

I don't even remember the patient and affordable care branding right there, right, so even Obama started calling it Obamacare. Smart beta is just a buzzword that you cannot beat down. People have come along, like Tom said morning Star Targic called a strategic beta, scientific beta, alternative beta, quantiment indexes. How about that one anti benchmark is the France calls it that active betas You just keep coming back to

smart beta. Smart beta sticks. It's sticks. But the words smart is what has made it controversial because at the end of the day, you may or may not outperform. You're just going to have a different return stream than a market cap weighted index. Okay, Eric, can we actually break this thing down and talk about smart beta in real life. Let's call it a case study. Do you have an example of a smart beta e t F and can you walk me through how how it did

what it did? Right? So, here's a classic one came out in two thousand five. So this is like early settler smart beta product, right, This was the Power Shares FO. I can picture it out in the homestead it Well, back then it was a lot of open frontier people put flags everywhere. Now that's why the t flants. He is very crowded, hard to come up with new ideas. There's not much white space left, so to speak. But

this really was one of the first ones. It's the Power Shares Foutsie Raffie US one thousand portfolio tik R PRF can see that again. No, Um, here's what it does. It's pretty simple. It tracks stocks based on four fundamental

measures right book value, cash flow, sales, and dividends. So it just screens stocks a thousand stocks by those metrics, comes up with a score, sorts them by that, and then every quarter it looks for which ones go to the top, and then it waits them by the score, and that's the that's how the index works, and that's what the e t F tracks. It just that's all it does. And it it goes on like a little robot. It is. It's a total how often does it rebalance quarterly?

So it is it's almost like a robotic version of a stock analyst, right, because it's doing things that a researcher would look for. Those are definitely popular fundamental metrics. Here's where I think this is a great example of how it works, especially on the lack of emotion side. In two thousand and eight, right bank stocks were hated. Nobody wanted to buy City Group at any of these stocks. Well, as you know, they got cheaper on a value ation

basis because everybody sold them. Well, this thing is a robot. It doesn't it doesn't read the news, it doesn't know what's going on. It isn't not getting yelled at by clients. So it rebalanced into financials in a big way. It had fifty financials in the beginning of two thousand nine. Doubled down on it, doubled down it went. It went into the burning building, as Warren Buffett would say, big

time with with a suit of gasoline. And on top of that, I mean, like, I assume maybe the guy in charge of this who is whom so the person who made the indexes Rob or not, and I'm guessing Rob maybe got some heat for that he did. So I interviewed him from my book and he said that institutional funds that tracked that index on a separate account basis called up and said, do not do the rebalance. We do not want to do this exactly, and in separate account you can do that. The e t F

cannot well guess who won after five years. Basically, that rebalance accounted for almost all of the firm's out performance over the next five years and came from the financials read that one rebalance. Now Ben Johnson the Morning Star calls it the immaculate rebalance. He thinks that I'm bringing

up a extreme situation. He also brings up that a lot of investors in the e t F left too because they couldn't handle it, and so part of smart beta, this brings up the behavior if you really want to benefit from it, and the lack of emotion, you have to hang in there. So the e t F did its job going the burning building, but a lot of investors couldn't handle the heat either. So that's why all

of that is important to point out there. But that is an example of how the smart beta can work for you and arguably be better than a human being manager. Near do you have a case study that rivals erics? Well, and I don't know if it rivals erics, but it's a little bit different. Okay, why not? Okay, yeah, let's let's let's let's get it on. Um. There are two et f s that I wanted to bring up that illustrate the point that I made earlier about giving you

different types different depths of exposure. Um. So, for example, I looked at value at the at value as as an active strategy, and one value e t F, which is basically a factor, right, like to simplify that, like value and there are many different types of factors. Value is basically probably the most famous one, right, Yeah, it's most famous, and for a good reason, by the way,

because in the it has it works very often. I mean, in other words, if if you looked, if you back tested all these various types of factors value and quality and momentum and so on, the batting the success rate for value over rolling periods is exceedingly high, so it's very popular over time, that's right. And it's also intuitively appealing, right because it makes sense that if you buy a company that's beaten down, you should get paid more than

a company that's not. Right. It just that has intuitive appeal and the and the you know, and the numbers check out. So that's why it's so popular. And there are there are two different ETFs that you can buy that give you different types of exposure to it. One is VTV, which is the Vanguard Value e t F, and that E t F sorts stocks based on a value uh based on a value sort, and then awaits them by market cap. So that's one way that you

can get value. But by contrast, you can also buy a different value t F that's v l U E, which is the I Shares Edge m S C I U S a value factor E t F. Don't ask me why these names have to be this long. And the difference here is that this two sorts by value, but then it also waits by value, and so the difference is you get more value exposure in the Eye

Shares Fund than you do in the Vanguard fund. That that doesn't make the Eye Shares fund better, but it allows investors to express a preference as to how much value they want in their portfolio. If they want more, they go for the eye shares. If they want less, they go for the vangord Um. I would like to use a metaphor we Tom and I we use that. We have this thing called the smart data spectrum and what Near just described. If you could picture a spectrum. On one side, you have v t V. It's got

just a little bit of value. It's going to do better if the regular market to doing well because it's mostly bulk beta. V l u E is sort of in the middle um and the value factor in the name is important because when you see that, that means it's waiting by the factor that's going to give you more juice. It's almost like v t V is o duels and vlu E barely any alcohol, and we have to think like like two cases to get you know,

buzz the middle. There is vlu E that's going to be more like just a regular beer like a Budweiser. But then there's even ones that go further that are more hardcore value. Because v l u E and Near probably knows this has a volatility screen, So it's got this like screen to kick out really hardcore value stocks because it's trying to sell it to advisors who don't

want that crazy of a ride. But there are more pure value like west Gray's q val the quant shares that are on the far end, which would be like that German beer that has exactly So I think this is a fascinating development in the E t F world. In this could make smart beta confusing to people, but really what you got to figure out is how much juice or factor content, how much aggressiveness do you want in this smart beta e t F because they have all flavors, Tom, can you give me a case study

the tops erics. Yeah, so mine's a little bit different in that, you know what the example that Eric gave is more takes the mind of the act of manager and it kicks out the emotion. Right. This the product I want to talk about is a little bit more about targeting a specific outcome or helping somebody targeted outcomes. So let's just say you want to own the market, but you want to own it in the least vollowed a way. You don't want to own the riskiest stocks.

So I want to bring up SPLV, which is the SMP five Low Volatility et F by Power Shares. The name long enough. I was gonna say, Eric, we should do a whole episode about the longest names in the e t F in the et F world. A new one was just filed that broke the record. Really Yeah, the goobelly pet parents, Pet companions and their parents and pet Ecosystem TMF. What I know, there's a multiple reasons why that's insanely amazing. We don't know yet, but it's

gotta have five. I think it's gonna be kitty or doggie, but um, that's a whole different story. A couple of east also have thirteen fourteen words in the name, but um, that one's long. Okay, back to SPLV, uh sure, And why I wanted to highlight this one is because it's in a smart bit of category that's gotten pretty popular. It's just it's low volatility, right, so it's owning the market in the least volatial way. So this launched back

in two thousand and eleven. And if you remember what happened in the summer of two thousand eleven was the U S got downgraded by the SMP. There's a lot of market volatility, and this thing kind of got put on the map like, hey, it's down less than the market. So it's very simple messogy it is and it's very simple, and I think this is why it's had some success is it takes the SMP five hundred and it says we are only going to take the one hundred least

vottle stocks. It's very simple, right, so you're gonna own on hundred least bottle stocks in the SMP. So when you look at you know, some big draw sounds in the SMP, it's down less, holds up a little bit better. So it's kind of maybe like a little bit of a foam O E t F that you still want to own the market, but you want to do it in at least volowed away um. And it's twenty five basis points. It's been out for a lot. It's gotten

pretty big, about six six or seven billion. Also like that you didn't uh, you didn't pampa product that you used to work on. That's that's classic of you. And let me talk. I want to add on to this because it's interesting. When SPLV came out, it tracks just those one stocks, so it has no sector. It doesn't care where it just goes where it ends up, having typically overweight to utilities and staples, which are always usually

the less volatile stocks. So some investors think, oh, well those are more susceptible to rising rates, or they don't want to be overweight these sectors. So our Shares came out with a version that has sector bands, and then there's multiple products that do a little of both and so but SPLV was like sort of the speaking of the frontier. That was like the first one that nailed

down low vall. Now there's probably forty five produc that do some twist on that to sort of again it's like soda flavors or whatever, and they serve it up in different ways. But SPLV was the first. How often does it change those one stocks that it holds. It does it every quarter. Every every quarter, it's going to rank the stocks and it's going to take the one hundred, which can be tough because let's say utilities got creamed, right, You're gonna have to take some down performance until let

thing rebalances into wherever the next low ball is. That's why these things take a stomach Okay, I love these case studies that really helped me figure out sort of how these products can perform nearer. I'm gonna come back to you because in addition to writing for Bloomberg, Godfly, you also touch other people's money right right Well, in addition to writing for Bloomberg, I also run an asset management firm. Um, so you know, I manage money for other people, and um, I am. I've always been a

big believer in active management. I think that the evidence for are certain types. There's a lot of quackery out there, without question, but I think, um, the evidence for the types of factors that we're talking about today, Um, you know, value and some of the other's quality, momentum and so on, I think is is well documented in the academic literature, and I think not controversial. Everyone agrees about it and

so on, um and so um. And so I've I've been sort of an early adopter of these smart beta funds just because their active management more cheaply. So, if you believe in active management, and you should pay as little as possible for it, and so smart data is perfect for that. The question is, Okay, now you've got all these options, what do you do with them, And this is where it's early days, and there's a lot

of confusion about what to do. But what I would propose and what I actually do is I use them for simple diversification. You know, it stands to reason that if you don't know which strategy is going to do well over the next period, then you just want to diversify across these strategies. In my opinion, it just makes sense to instead of putting all your eggs in the market cap index or value index or whatever, have exposure

to various types of things. And these smart data products allow you to do that relatively cheaply, and I think that's the first step on the bus. If investors take away anything from this podcast, in my opinion, what they ought to take is look at your portfolio, see what kind of exposures you have. If you have too much in one particular type or style of investing or factor, however you want to call it, then look at look at smart data funds and diversify across them so that

your eggs are in different baskets. Which puts me back in a dark room touching an elephant um tom when you are on the other side of the table. How are you guys seeing investors use this both from like a retail perspective but also like the institutional Yeah, so I think it really comes down to, now the ets that are coming out, they're trying to solve a problem, right, So it really comes down to what are you trying

to solve? So are you using an active manager that maybe you're not happy with, like you have a value manager, Maybe you might want to look at a value smart beta et F Do you want to be in the market, but you want to be in the lowest vault as possible. So it's about talking to your clients, are talking to investors and finding a problem. It's not just all the tools are now out there, right, the toolbox has gotten really big. It's just about figuring out what are you

trying to accomplish. And that's the conversation we constantly have with clients that this is the problem that I have. I want income, but I also want low vall income. So let's build a product that will give to you, let's say, dividend paying stocks, but also with like a low vall component to it. Solutions, Yeah, it has them exactly. Heyntroll here now that I'm the editor of Bloomberg business Week. I pulled a few strings for our loyal podcast listeners.

Go to business Week mag dot com slash trillions right now for a thirty day free trial. If you like what we're doing here on trillions, you're gonna love the stories that we published in Bloomberg business Week. Here's that special offer one more time. Go to business Week mag dot com slash trillions for your free thirty day trial. Thanks. Okay, last topic, what kind of due diligence should investors be doing before they pick up these tools? Um, okay, I'll

take a crack at this. So when I look at smart beta again, we have this spectrum and the way we determine where on the spectrum it goes. Again, the more quote beta that is in it, the more it could just be a replacement. I think. The more volatile it is, the more you could add it on as like a little bit of hot sauce. But anyway to determine what you're looking at, I would suggest a few things. One is the index waiting methodology. Does it wait by

market cap? If so, it's probably gonna be not that volatile, not that much exposure to any factor or anything. But you get a little is it weighted towards the factor itself? That's important. That's number one. Number two is the standard deviation, which it's a simple term. If you fell asleep and stats class like I did, I had to relearn it,

but so useful. It's just basically looking at past volatility of this fund or stock or whatever it could be, use for anything, and just telling you how bumpy the ride will be. It's like almost like a ski slopes line, like is this a black diamond or a blue square? So standard deviation is basically how bumpy the ride will be. But you need it relative to something. So I said, just taking the standard deviation of s P Y or the SMP fire, which I believe right now might be

around nine. That means there's a two thirds chance that the annual return of the SMP over the next year will be one way or the other, up or down. So where is it versus nine percent? If it's you are going to have a real volatile smart beta product. If it's nine, it's about the same. And there's some that are lower, like the low volley t F might be more like eight percent, So figure that out. That is huge because you don't want to buy something that's too spicy for you or too lame or you know,

doesn't move around enough. So I think those are two important stats. And then of course the fee I think ast matter here and now you can get a smart beta e t F for under twenty basis points. Uh, so you should shop around a little bit. Although when you're swinging for the fences, the fee isn't quite as important. But I think expense ratio is interesting because the range now is from a D to nine. There's a big range, and there's a lot of cost pressure going on in

this space. So near when when our two D two with the head of Peter Lynch shows up at your door, what what do you do? Well? I think the I think as an investor, you want to look at UM if you look at nothing else, you want to look at what's what's the factor that I'm buying and how much am I paying for it? I think those are one and two. But if I if I can UM, let me, let me just use the time I have for just just a little bit of advocacy for this industry.

I think I think there's something very important that we need to solve for UM and I think we need to solve for it very quickly if if smart beta is going to take off, and that is, we need to have some sort of labeling system to continue the analogy from earlier UM that tells you how much alcohol

content is in the e t F is in this factor. So, in other words, you need you if you're looking at five value value factory t s. Let's just say you have no idea how much value is in one versus the other, and so as a consumer you can't make it a smart decision about which one to buy. And so we need to come up with a standardized system to be able to say, right there almost like an expense ratio, like you know what it costs, right It's almost like an expense ratio that tells you this has

this percentage of value in it. And we can do in any We can do it on a ten point scale, we can do it on a D scale, we can do it in any way you want. But we have to do it, and there's a way to measure it. It would be very easy to do. The industry is going to push back against it because I don't think ultimately I think they want this to be UM somewhat confusing because it's very difficult to differentiate um if you

make a lot of information available to investors. But I think we have to insist on it, and we have to give investors that tool so they can they can discriminate among the products. Spoken like a true Bloomberg Gadfly columnist Tom, we set out to explore the mystery of smart beta. Have we explored it? I think it's going to be an ongoing debate, not just you know, beyond this room, but it's going to be something that's going to keep evolving in the ETF industry because the lines

are getting very, very blurry. Even the new players atting in into the market, their traditional active shops that are now launching ETFs. Now there's actively managed ETFs. The lines getting very blurry. Well, you just heard a lot of different takes on it, and it really depends on where you're coming from. And you may find smart beta as a solution to a boring core passive portfolio. You want a little spice in your life, or you may have too much spice and paying too much for the active managers.

So you think underperforming the mutual fund structure, and you want to basically lower your fees and make it a more clean, um cheaper version of what you were getting before. So there's a lot of angles to this. Yeah, I like the hot sauce. Hot sauce. Hot sauce is better than the elephant. Alright near case are Tom Saraphagus. Thank you so much for us for Trillians, Thanks, thanks for having me, Thanks for listening to Trillions until next time.

You can find us on the Bloomberg terminal, Bloomberg dot com, Apple podcasts, and whether else you listen to podcasts. We'd love to hear from you. We're on Twitter, I'm at Joel Weber Show. He's at Eric fall Tunas. You can find near at near Casar and good luck spot on this one, but Tom's at at T Sarah Vegas. Trillions is produced by Magnus Hendrickson. Francesca Leedy is the head of Bloomberg podcast Bye.