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Smart beta is silly talk

Attaching other risk factors to market risk leads to, well, more risk (and higher fees)

By Rick Ferri

Aug 21, 2013 @ 3:27 pm (Updated 4:54 pm) EST

risk, beta, market risk, fama, french, arnott

According to its inventor, beta is neither smart nor intelligent, and there isn't a better beta or an alternative beta. In fact, beta has not changed in 50 years. The attention-grabbing spin on beta is a creation of investment firms that seek to funnel money into products that may have greater risk and higher fees than low-cost index funds that track markets.

Beta, as defined by Nobel Laureate William Sharpe, is the non-diversifiable risk of a market and by default has a value of 1.0. Beta is then used to measure the sensitivity of a non-market portfolio relative to market risk. A portfolio with a 1.2 beta has more sensitivity while a portfolio with 0.8 beta has less.

Some companies have retrofit beta into a “super beta” by attaching risk factors such as value stock exposure, small cap exposure and price momentum. Rather than representing these factors as additional risk in a portfolio, they say their new and improved betas are smart, intelligent, and better than market beta.

Professor Sharpe does not agree with calling these extra risk factors smart beta at all: “I tried many years ago to get people to use the term 'b' for the coefficients in a factor model, such as one in which the factors are value, size, etc. However, the industry and some academics have muddied the waters by using 'beta' for such factor loadings.”

Ken French, noted authority and co-creator of the Fama-French 3-Factor Model, agrees that a misused definition of beta is not in an investor's best interest, “I try to reserve the term 'beta' for sensitivity to the overall market. Using beta to mean other things can create confusion.”

Gene Fama, father of efficient market theory and co-creator of the 3-Factor Model, believes if risk factors are expressed as betas, the meaning should not be exaggerated. “Multifactor models have factors in addition to the market factor, and the additional factors have their own regression slopes, which can be interpreted as additional betas. The additional betas are not alternative or smart.”

Rob Arnott of Research Affiliates is less troubled by the terminology and for good reason. His firm is a leader in “smart beta” indexes and creator of the Fundamental Index (RAFI), a strategy that weighs securities using fundamental factors other than market capitalization. More than $100 billion is tracking RAFI strategies worldwide.

Mr. Arnott says: “I personally view this as a matter of semantics, the meaning of words: language evolves, and in technical fields it can evolve rapidly. Bill Sharpe invented the concepts of 'alpha' and 'beta' 50 years ago. I completely respect those who want to hang onto the original definitions, but the words have been used in somewhat fluid ways in the subsequent half-century.”

I believe the original definitions are best left unchanged. Beta is non-diversifiable market risk, other return dimensions are defined as additional risk factors, and putting these risks together in a portfolio is multifactor investing.

These definitions are clear, distinct, and stand the test of time.

Rick Ferri is founder of Portfolio Solutions LLC, which provides low-cost investment management services using low-cost index funds and ETFs and currently manages more than $1.2 billion in AUM.