Rolf Banz: «Bill Sharpe's Dim Views on Smart Beta»

Rolf Banz

Rolf Banz

Swiss finance expert Rolf Banz finds it sickening, that rather silly ideas are sold aggressively to ignorant investors.

This feature by our guest author Rolf Banz is the fifth contribution to our section finews.first. It is a forum for renowned authors specialized on economic and financial topics. The texts will be published both in German and English. The contributions appear in cooperation with Pictet, the Geneva-based private bank. The publishers of are responsible for the selection. Previous contributions: Rudi BogniAdriano B. Lucatelli, Peter Kurer and Oliver Berger.

«Advisor Perspectives» has run a story under the title «Bill Sharpe: Smart beta makes me sick». Since smart beta looks like it is going to be around for a while, Bill is likely to keep suffering for some time – if the story quotes his views correctly. But what seems to be causing Bill Sharpe such discomfort?

It seems that he is unhappy about two things; first, the label «smart», which implies that those who do not embrace smart beta strategies are dumb and second, the fact that not everybody could pursue those strategies.

«In the sixties, a US investor would not have had any interest in foreign assets»

Clearly, Bill is still caught in a world where his Capital Asset Pricing Model (CAPM) describes market equilibrium. If the CAPM were true, we would all want to hold the same portfolio (the «market portfolio») and perhaps some cash.

While it may have been reasonable to assume such a model in the sixties when the CAPM was formulated, it surely is no longer reasonable to argue in those terms today. In the sixties, a US investor (and all the relevant research was done there) would not have had any interest in foreign assets and one might therefore have argued that the (purely domestic) portfolios of all US investors were sufficiently similar in nature to allow a single factor model – the CAPM – to describe pricing.

«There is no such thing as a ‹market portfolio› that everybody could agree on»

But that was a very long time ago; by now, we ought to know better. Do we really still believe that a single factor describes asset prices globally? Can we just ignore additional factors that have been identified? Will the home country bias that all investors display to some extent have no impact on prices? What about the various barriers to investment in certain countries that still exist (and in some cases seem to get higher)?

Also, the various behavioural follies that investors display to different degrees will also have an impact on pricing. Consequently, the argument that certain strategies could not be pursued by everybody is completely irrelevant. There is no such thing as a «market portfolio» that everybody could agree on.

Consequently, whether a certain strategy could be pursued by everybody is irrelevant. The very fact that some investors would not – for behavioural reasons – or could not – for regulatory reasons – invest in certain securities will contribute to the mispricing of certain factors.

I would go further than Bill Sharpe and argue that the exclusive pursuit of market cap based strategies is actually not very smart. We used to choose market cap weighted benchmarks without giving much thought to the reasons.

«Smart beta is more than a marketing gimmick»

There were two; one, the macro consistency addressed above and two, the fact that the weights represent the economic weight of an enterprise. That second argument may have had some merit for equities when the total market cap was included; now, that only the free float is taken into consideration, the argument has lost its basis (or is Roche now suddenly less important as an economic agent just because the family controls over fifty per cent of the voting shares?).

Naturally, the second argument never made any sense for fixed income instruments: do we really want to invest blindly in those countries or enterprises that issue the most debt?

I think that «smart beta» is more than a marketing gimmick. There are some factors that seem to be mispriced even over the long run. I would include value, low risk, small cap and quality among these factors.

«Silly ideas sold to ignorant investors»

Many investors will tend to buy a product based on a factor that has recently done well without understanding the risks and may well be disappointed. But investors who understand the risks, have a sufficiently long investment horizon and the resilience to live through periods of disappointing performance, may well do rather better than by remaining the slaves of an established, market cap weighted – but ultimately completely arbitrary – index.

Personally, what I find sickening in our industry is not thoughtful ideas that are sold under silly labels but rather silly ideas that are sold aggressively to ignorant investors such as most structured products – designed to hide large fees and give the investors the illusion of getting something for nothing.

Rolf Banz is one of Switzerland's best known financial experts. After studying engineering at the ETH in Zurich he went on to do research and to teach at universities across Europe and the States, notably at the Graduate School of Business at the University of Chicago.

Together with his wife and some partners, Banz founded an investment boutique in London, which they sold to Alliance Capital (today AB) in 1991. Later, he worked in various leading positions at Pictet Asset Management, whose chairman he remains to this day.


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