Was Jack Bogle Right About Smart Beta?

Over time, practitioners have turned Sharpe’s mathematical definition of beta into slang. Beta no longer meant just the result of a calculation. The word could also be applied loosely to indicate the performance of an asset class. Using this, if US stocks gained 8% and long US Treasuries returned 5%, the betas of these two investments would be 8% and 5%, respectively.

Smart Beta Out, Strategic Beta In

Now we can understand the meaning of smart beta. The term describes a portfolio with returns that come solely from its beta exposures—which, and I really regret the extra jargon, are sometimes called “factors.” Smart-beta funds are passively managed, bypassing the ongoing decisions of portfolio managers. However, unlike rival index funds, which represent an entire market, smart-beta funds choose their niche. They are looking for more than duplicating reality. They expect to improve because they are “smart”.

I know it all sounds vague. Three illustrations should flow the fog. Examples of Smart-beta investments include passively managed funds that hold stocks that:

• to pay large dividends;
• have recent high gains on the stock market; or
• are issued by companies that combine above-average earnings with below-average debt.

That is: they use mechanical rules to build portfolios that are marketed as superior to benchmark indices.

Of course, labeling a fund as “smart” doesn’t make it so. (If only investing were that easy!) For this reason, many researchers have rejected the smart-beta label, Morningstar among them. Its official term is strategic beta. Accordingly, I will now turn to that nomenclature.

Jack Bogle’s verdict on Smart Beta

When I first wrote about strategic beta funds, I was supportive, declaring that they were “here to stay.” Most fund inventions fail because the new offerings tend to be extravagantly priced. In addition, they use untested strategies that often surprise their shareholders. But because strategic beta funds were passively managed, they would avoid these problems by being cheap and performing predictable.

With these perspectives, I was right. The average annual expense ratio for strategic beta funds today is 0.38%. And their portfolios have no secrets. Unlike their actively managed rivals, strategic beta funds do not “deviate” from their investment approaches. As a result, they have proven they are here to stay, as they now control $2.3 trillion (£1.7 trillion) in fund assets.

What we overlooked, however, was whether smart-beta investors would choose well. After all, smart-beta funds are a cousin of sector funds in holding a segment of a market. And sector fund shareholders have fared poorly because of their habit of buying high and selling low. They track performance.

That was Jack Bogle’s concern. In the same year that my relatively sunny article appeared, Bogle analyzed strategic beta funds: “sometimes (investors) will pick the right factor, sometimes they’ll pick the wrong factor, but to the extent that investors pick the hot factor, they almost certainly will mistake.” Such funds, he concluded, were “bullshit”.

What are investors buying?

Let’s see which proved more correct: Rekenthaler’s optimism or Bogle’s pessimism. (Being on the other side of Bogle is a troubling position.) Our starting point will be the largest beta strategic funds from 10 years ago. Were 2014 strategic beta shareholders tracking past returns or investing strategically looking ahead? In both cases, how did their funds perform?

The good news: they invested wisely. Among the 10 largest strategic beta funds as of September 2014 that held all US stocks, 51% of shareholder assets were in value funds, 38% in growth funds and 9% in mixed funds. On average, these funds have slightly outperformed the Vanguard Total Stock Market Index VTSAX over the previous decade. In short, the first generation of strategic-beta investors did not track performance.

The bad news is that they didn’t profit from their decisions. Over the next 10 years, from September 2014 to August 2024, the asset-weighted return for those 10 funds was 11.50%, compared to 12.31% for the Vanguard Total Stock Market Index. To be sure, this back-of-the-envelope calculation doesn’t tell the full story, as money has flown in and out of those funds, but it suggests that smart-beta investors would have profited by following Bogle’s advice.

Allocations made by strategic-beta investors are similar today. Of the current top 10 list, 49% of assets are in value funds, 40% in growth funds and 11% in mixed funds. These numbers are nearly identical to 2014’s totals, indicating that once again investors in strategic beta funds are well diversified.

But the winds are changing. Among this year’s 10 best-selling strategic beta offerings, funds that outperformed the Vanguard Total Stock Market Index over the past five years received 80 percent of net new sales. Five of these 10 funds openly trade as growth portfolios, while two more favor high-quality companies that trade as growth stocks. This development, it must be confessed, evokes Bogle’s concern about “hot factors”. It seems that after many years of resistance, strategic-beta investors have decided if they can’t beat growth funds, they should join them.

Why Bogle’s warning is relevant

Jack Bogle has yet to make me look stupid – not on this subject anyway. For most of the short history of strategic-beta funds, their shareholders have spread their bets rather than piling in on recent winners. True, most did not benefit from these decisions. As Bogle predicted, strategic-beta shareholders would have made more money if they had tried to be less clever and instead simply bought a standard US stock index fund.

However, current sales figures suggest that Bogle’s warning is now relevant. Not only do growth funds dominate inflows, but the powerful Vanguard Value Index VVIAX, which for many years has been the second-highest beta strategic fund, has fallen off the best-selling list entirely. Such behavior is reminiscent of sector funds – and that is not a compliment.

John Rekenthaler is Vice President of Investment Research at Morningstar. He does not own shares in any securities mentioned in this article. Learn about Morningstar’s editorial policies. The views expressed here are that the Morningstar author values ​​diversity of thought and publishes a wide range of viewpoints.