The word “smart” is thrown around a lot these days to describe phones, tables, and a host of other gadgets intended to make our life easier. But, as we know, the mere existence of capabilities doesn’t necessarily mean those capabilities work well. Rob Arnott, founder of Research Affiliates, discussed this as it relates to the “smart beta” investment strategy.
“Smart beta” describes a portfolio-building strategy that focuses on a company’s fundamentals (such as revenue, book value and cash flow) exclusive of its market capitalization. Arnott asserts that because the methodology is applied doesn’t ensure it will be successful. Like all strategies, it can move in and out of favor (he cites the example of the performance pivot between growth and value stocks over several-year periods). That is, at some point, what is in favor will move out of favor.
So why do people use such a strategy? Arnott says that it boils down to past performance, which can lead to the paradox where the favored stock or fund then becomes more expensive and the beta strategy goes from smart to not-so-smart (see our blog on low-volatility funds). Therefore, the relative value of an investment should be considered before buying into it. Otherwise, the strategy can result in big disappointment when historic market patterns reverse.