Smart Beta, Factor Analysis and The Illusion of Financial Innovation

Back in 2019 and 2020, I wrote a couple of different articles at Rathbones about the illusion of smart
beta and the fallacy of dividend seeking ETF funds. A clever marketing pitch and the claim for
innovation hid an underlying fallacy. While I did not expect Covid to happen, overreliance on
quantitative screens and strict KIID were a misstep. For example, ‘passive but active’ ETFs bought
troubled businesses at artificially inflated dividend yields with plunging share prices. Still beware the
jargon; not much has changed.

The key takeaway remains quite clear. Factor based strategies might even look more popular now
and smart beta has been positioned as a hybrid between passive efficiency and active
outperformance, but most of these strategies are neither particularly ‘smart’ nor suited to longterm
private clients.

There are investors who believe that it doesn’t pay off to do research and markets are inherently
efficient. It makes sense. These investors would buy an ETF, which tracks at low cost a market index
(i.e. the S&P 500 in the US). They won’t do better or worse than the index and their returns will
replicate market performance (‘beta’). Other investors think that if you do your own work and you
are a stock picker, you can uncover unique ideas, which are not properly understood and will raise in
value when their true potential becomes evident. It also makes sense. Active investors can make you
money well in excess of market returns (‘alpha’), but at times they can also disappoint.

There is the illusion that it’s possible to get the best of both worlds or ‘Smart Beta’ i.e. a low-cost
passive approach with the brains of an active manager. Factor-based ETFs (such as growth, value,
momentum dividend yield etc) offer convenient exposure, but in practice have structural flaws.
Providers can always back test strategies to look compelling on paper, but no single approach works
reliably across all market environments.

As we manage client portfolios, we conduct our own research and select individual stocks. We also
like to invest in external managers which we believe are best-of-breed and have the capability to
make money for us, so select those that offer decorrelated strategies and styles. In addition, we use
market index ETFs which are coherent with our asset allocation strategy. As investment managers,
we make an assessment when it’s appropriate to have higher market exposure, in which
areas/regions or sectors or funds are most suitable at any given time. The same applies for our
positioning in bonds and interest rates. We don’t follow a rigid formula, rather, we rely on a
repeatable, common-sense approach that has served both us and our clients well over the longer
term.