Rick Ferri on Smart Beta

“Nothing fails like success on Wall Street.” – Rick Ferri

I attended the Morningstar Conference conference in Chicago this week and listened to a great talk on smart beta and quantitative investing that included Rick Ferri of Portfolio Solutions.

Here are some of my notes on Ferri’s talk (not all are necessarily quotes):

  • Smart beta strategies just had one of the best 15 year periods ever to backtest against cap weighted indexes.  Any of these strategies are going to look magnificent against simple indexes when comparing performance numbers over this time frame.
  • Many of the people touting smart beta don’t even understand what regular beta is.
  • Smart beta has 3 disadvantages:

(1) The cost of beta is basically free (after netting out expenses with securities lending practices). Anything other than beta is more costly so there’s a hurdle rate.  These hurdle rates can vary depending on the fund choice so choose wisely.

(2) There is always more risk in smart beta. There’s really no such thing as smart beta, just additional betas and risk.

(3) There are very long periods of underperformance with these strategies.  Small cap value underperformed for 18 years in the 80s and 90s. The question is: Can you hang on? Unless you thoroughly understand it there is huge capitulation risk.

  • Small & value strategies have been working very well since the late-1990s. What is the risk premium going forward net of costs? It’s much lower now than it was in 1999 so it’s possible you might not make up those costs going forward over the next 15 years.  Of course, if that happened you could probably expect the following 15 years to work once again.  This is how the emotions of investors work to make the markets function in cycles.
  • Ferri’s concern is that if you haven’t been in smart beta is now really the best time to pile in?  Investors might be a little too late at this point in the cycle.  If you plan on jumping in now, make sure you’re ready to be in for the rest of your life. You have to commit to it and stick with it over multiple cycles.
  • Premiums in the market do exist but they come and they go. What is the supply of excess return in the market? Ferri says he doesn’t know (it’s an unanswerable question). But when everybody wants to do something, it’s not usually a good time to do it.
  • Also, Ferrri touched on the robo-advisor craze.  He thinks they’re great for advisors. Younger investors that are saving money, paying low fees and diversifying are going to need advice some day for the wealth they accumulate. They will make great clients for advisors eventually.

Ferri is one of the most levelheaded, common sense voices in the world of finance, so when he talks I pay attention.

Basically, as with all investments, know what you are getting yourself into.  Understand the process and reasoning for investing in any strategy, whether it’s factor investing, index funds, active management, trading or anything in between.

Also, it’s important to realize that any style of investing can go through huge periods of over and underperformance.  That means determining the correct allocation size of certain strategies within your portfolio and diversifying among investment classes.

These lessons apply for smart beta (or whatever you want to call it — factor investing, quant investing, etc.) or any style you include in an overall portfolio.

For more on the smart beta phenomenon, Tadas put together a panel of finance bloggers (myself included) at Abnormal Returns to give their thoughts on smart beta:
Finance Blogger Wisdom: Smart Beta Trends (Abnormal Returns)

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  1. Marc commented on Jun 21

    Thanks for this interesting article, but this article was difficult to understand since the term “smart beta” is never precisely defined. I had to search your website and read a different article to learn “Smart beta is basically small and mid cap value but with higher fees” and understand what this article was addressing. It would be helpful if in future articles you would always define what the subject matter is.
    By the way, I totally agree with you that any style of investing can go through huge periods of over and underperformance, which is why I advocate simply buying the VTI (total market index) which will eventually capture all style investing returns without the angst from possible poor timing.

    • Ben commented on Jun 21

      Good points. I’m glad the article got you to seek further sources since I didn’t explain it well enough. Here’s another one from Ferri on the topic if you’re interested in reading anything further:


      But it sounds like you have the right idea. Either way, know what you’re getting yourself into.

  2. Eric commented on Jun 24

    Ben –

    Really been enjoying the blog. I agree with some of what Rick said here, but I do think it’s important to look at “smart beta”, or more appropriately simply diversifying across smaller and more value-oriented stocks (which is basically all these smart beta/fundamental index approaches are) a bit more critically. Looking at S/V “tilting”:

    It is true that S/V underperformed in the 80s/90s, but who cares? Simple beta was going bonkers! CRSP 1-10 earned +17.4% over this period. FF SV xUtility Index did +16.6%. So, yea, tilting didn’t exactly juice returns, but it’s not like you needed them too either! Not sure how many were losing sleep over 16%+ returns.

    Also, lopping off the years of 98-99, looking at just 80-97, TSM did +16.6% and SV did +19.0%. So it’s not like small/value tilting endured 2 straight agonizing decades of underperformance – it was more like 2 brutal years at the end (98-99). Or, conversely, adding 3 more years from 1980-2002, we see +12.6% for TSM and +15.2% for SV – almost identical to the 3.5% or so SV outperformance for the last 80 years.

    Finally, as I alluded to earlier, one man’s “underperformance” is another’s “diversification,” as seen here:
    1966-1981, TSM = +6.5%, FF SV xUtility Index = +14.2%
    1982-1999, TSM = +17.8%, FF SV xUtility Index = +16.3%
    2000-2013, TSM = +4.3%, DFA US Small Value fund = +12.2%

    In the first period, stocks (TSM) failed to produce real returns, but SV helped prop up a portfolio’s long-term return, more than doubling the TSM result. In the second, stocks (TSM) went bonkers and SV took a bit away from returns but overall results were still breathtaking. Finally, in the third, stocks (TSM) again barely produced a real return, and SV tripled the result of the overall market.

    As an investor, it seems you can bet it all on big blue chip stocks (TSM), or you can spread your assets out more gradually while emphasizing a bit more size/value. The former seems like a big bet on another 82-99 bull market, the later instead appears a bit more diversified in the long-run.

    That being said – there is good “smart beta” (hate that term) – which are traditional small cap and value cap-weighted indexes/asset class funds or DFAs Core/Vector funds. And there are bad “smart beta” strategies – which in my book include almost everything being marketed by ETF providers these days with fundamental weighting schemes and too-good-to-be-true simulated index returns.

    Keep up the good work!

    • Ben commented on Jun 24

      Good point on the late-90s. That was also the nice set-up for the early 2000s small cap outperformance.

      Like you, I’m most concerned about the new products being rolled out and investors lumping them all into the same category just because they are marketed as smart beta. Should be interesting to see what happens to the Johnny-come-lately crowd during the next downturn.

      Your point on diversification is exactly why even with these factors that work over time, you still need to have other tilts to be able to make it through the rough patches. Hopefully investors understand this and don’t simply try to pick one factor to rely on and then capitulate.