Bill Sharpe: «Smart beta makes me sick»
May 13, 2014
by Robert Huebscher
If you rely on «smart beta» strategies to achieve returns that you hope will beat the broad market, then you also need a response to the criticisms posed by Bill Sharpe, the Nobel laureate and Stanford economist. Sharpe uses unassailable logic, in my opinion, to demonstrate why smart-beta strategies must eventually do no better than the market.
«When I hear smart beta, it makes me sick,» he said.
Sharpe spoke at the CFA Institute Annual Conference in Seattle on May 5.
He also explained why a static 60/40 asset allocation has important limits. But let’s look at his criticisms of smart beta first.
Sharpe did not offer a precise definition of which strategies he would include in the definition of smart beta. But in an email exchange, he wrote that it would at least include portfolios that overweight small- capitalization or value stocks, as well as alternative weightings, including fundamental indexing.
The question Sharpe posed for a smart beta portfolio is whether it can be good for everyone. If so, then that would imply that he and his friends are dumb, because they hold the market portfolio.
Other investors who underweight those stocks that are overweighted by the smart-beta strategies must be «really dumb,» he said.
The market must therefore be divided between smart, dumb and really dumb investors.
«If that’s your story,» Sharpe said, «then smart beta is a way to exploit stupidity.»
«If so, then I would suggest that before too long, the really dumb ones will at least begin to choose index funds,» he said. «Maybe some of the Index-fund people will try to move in your direction,» at which point the advantage of smart-beta funds would be eliminated.
«I think there are all kinds of confusion out there,» Sharpe said in regard to smart beta. «I don’t think it will work in the future.»
He said he has seen what appeared to be empirical evidence of alpha, only to see that alpha fail to show up in other countries or disappear after a few years. He acknowledged that some strategies, like fundamental indexing, rely on proprietary methods and cannot be replicated mechanically, and therefore he cannot say for sure whether they would fail such a test.
Sharpe used a similar line of reasoning to explain why a static 60/40 asset allocation cannot work for all investors. If a particular strategy is good for some investors, then it can only work in the long run if markets can «clear,» he said. That means that the strategy must continue to offer its benefits regardless of how many investors pursue it.
Consider an average investor or institution who wants to take as much risk as possible and get the same expected return as the overall market. If the capitalizations of the stock and bond markets are in a 60/40 proportion, then all investors can have this allocation.
Imagine, Sharpe said, what would happen if stock prices rose relative to bonds, and the market was weighted 70/30. Now, to have a market portfolio, you should be 70/30.
But virtually all investment policy statements are written with static allocations, such as 60/40. In that case, to rebalance, investors must sell winners (stocks) and buy losers (bonds).
Here’s the problem: Not everyone can do that, at least at then-current market prices. Markets would not allow all investors to revert to a 60/40 portfolio.
Adaptive asset allocation solves this problem by replacing a static asset allocation (e.g., 60/40) with a dynamic one that allows investors to be 70/30 when the market is weighted that way. Sharpe also said he derived a formula that determinates how to allocate your portfolio if you want to be riskier or less risky than the market.
Returning to the topic of smart beta, Sharpe acknowledged that index funds have their limits too.
«We absolutely need people who are looking for mispriced securities,» he said. If all investors held index funds, then the shares of those funds would be bid up. Active management provides a social service, he said, that benefits index investors.
He said he used to worry about too much indexing. «But human nature is such that people will continue to look for under- and overpriced stocks,» he said. «I stopped worrying.»