I am increasing frustrated by the growing number of fund companies that claim the indices they follow in their ETF offer a “better” beta, a “smart” beta and most outrageous of all, an “alpha” beta. There is only one beta, and it is the market. Everything else is marketing spin.
Academics worked hard during the 1960s to create simple risk-based models for evaluating active manager performance. Their work concentrated on separating market returns from manager returns, and then adjusting for market risk. They surmised that every portfolio of securities has two elements of risks: systematic risk, which is the risk of the market in general, and unsystematic risk, which is added risk from the specific portfolio structure.
All portfolios have some degree of systematic risk because the securities in a portfolio are part of the total market. Systematic risk cannot be diversified away by adding more securities of the same asset class. In fact, the more securities added to a portfolio, the more the portfolio sheds unsystematic risk and inches toward pure systematic risk.
Systematic risk was first labeled as beta (ß) by William Sharpe in a 1964 paper entitled “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” He elegantly laid out his case for adjusting portfolios based on their individual beta to better compare returns on a risk-adjusted basis. Sharpe’s work would eventually lead to a Nobel Prize in Economics Sciences.
The development of beta led to a quantum leap in portfolio valuation techniques. These include, but are not limited to, the Capital Asset Pricing Model (CAPM), the Treynor Ratio, and Jensen’s Alpha, which labels the excess return from a portfolio over beta as alpha (α). These models are still used today to compare portfolios after adjustments for systematic risk.
With alpha and beta defined, academics separated active managers between those who had alpha and those who did not. Most did not. This separation lead to more questions: how does one determine luck from skill and how does one pick a skillful manager in advance? These questions remain unresolved.
There have been several important advances in risk factor identification that help explain portfolio returns in addition to beta. For example, the Fama-French three-factor model breaks return down in three dimensions; beta, company size and a book-to-market factor (BtM). The three risk factors are independent of each other with beta being the most important in the three-factor risk formula.
This brings me to the point of this article. Much of the excess return from so-called better beta indices are actually excess returns from small company risk, value risk and other known risk factors. There is very little evidence that these mechanical investment strategies have generate any excess return on a risk-adjusted bases.
The ETF industry is suffering from a bad case of beta diarrhea. The marketers spin a tale of better beta, smart beta, and alpha beta without disclosing the added risks. They believe that clever labels are the key to enticing ETF investors and advisors. That might happen for a short while, but it won’t take people long to figure out the truth.
It would be more ethical and transparent if the fund industry admitted to relying on known risk factors for potential added return, in addition to beta. I’d even be OK if they called these indices “beta plus” or “beta augmented” to acknowledge that beta is the primary driver of return and that some other unsystematic risk(s) are embedded in the strategy, for better or worse.
Index methods have come a long way since their beta tracking roots; unfortunately, investor education has lagged far behind. This gap has allowed less-than-ethical marketers of products to fool the public about the sources of excess return. The beta diarrhea spreading across the industry needs to be cured, and the best medicine is full disclosure about risk.
For a detailed discussion on index classification, see The ETF Book, 2nd edition, Wiley, 2010.
