Journal of Financial Planning: September 2015
Rick Ferri, CFA, is an investment adviser, speaker, and financial writer. He continually monitors the latest trends related to index funds and ETFs. His research appears frequently in many major media outlets.
Smart beta has become a phrase for automated investment strategies not following cap-weighted market indices. Advocates suggest these strategies offer superior performance, yet I haven’t seen the evidence proving they outperform after adjusting for risk and cost. Registered Investment Advisers (RIAs) and their representatives should avoid using the phrase “smart beta.” It’s unproven at best, deceptive at worst, and may violate SEC regulations.
Section 206 of the Investment Advisers Act of 1940 (The Act) “prohibits misstatements or misleading omissions of material facts and other fraudulent acts and practices in connection with the conduct of an investment advisory business.”
Sections 206(1) and 206(2) prohibit RIAs from employing “any device, scheme, or artifice to defraud any client or prospective client,” or from engaging in “any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”
The Act also imposes a fiduciary duty on RIA representatives, which includes duties of loyalty and care. An adviser must deal fairly and impartially with all clients and prospective clients, including necessary disclosures of material facts so clients can make informed decisions. Violations don’t have to be intentional. Negligence regarding misstatement and disclosure may establish a violation of Section 206(2).1
RIA firms promoting investment strategies as being smart have to prove so under SEC regulations. But are smart beta strategies smart?
The answer depends on who you ask. I sourced three viewpoints for the answer: a product provider, a media source, and an academic.
The first is from the self-proclaimed provider of smart beta products, Research Affiliates—the firm that creates multi-factor investment strategies and licenses them to mutual fund companies and ETF providers:
“Smart beta strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio holdings on the basis of characteristics other than market capitalization. ... They have the potential to achieve results that are superior to the market returns of cap-weighted benchmarks at lower cost than active management.”
ETF.com, an investment research and media company with no direct stake in whether smart beta strategies outperform, describes the strategy in The Definitive Smart Beta ETF Guide as:
“[S]mart beta is a catchall term for rules-based, quantitative strategies that aim to deliver better risk-adjusted returns than traditional market indexes. ... As with anyone promising a free lunch, however, the old caution applies: [b]uyer beware.”
Finally, Nobel Laureate Gene Fama, father of efficient market theory and co-creator of the three-factor model:
“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,” Fama said in my Forbes.com article. “The additional betas are not alternative or smart.”
I’m not a lawyer, nor am I an expert in compliance matters. I’m an RIA firm owner with a fiduciary responsibility to do what’s in the best interest of clients and potential clients. So, who should I believe?
Fama has the most credibility in this discussion. When he says multifactor strategies have additional risk factors called additional beta, not smart beta, that’s good enough for me.
The SEC has rules designed to protect the public from fraudulent or deceptive practices. Any RIA representative inferring an investment product or strategy is smart with no solid proof that it is, may find him or herself in an uncomfortable regulatory situation.
Endnotes
- See SEC v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992).