Jason Hsu and Rob Arnott have been developing smart beta strategies for years, most notably the RAFI Fundamental Index approach.
This article originally appeared in the April/May 2014 issue of Morningstar magazine.
This interview occurred Feb. 14 and has been edited for clarity and space.
1. What’s more challenging, dealing with institutional clients or teaching college students?
Institutional clients by a longshot. Most of the students I teach appear to understand that three years of performance data do not provide any useful information from which to make investment decisions.
2. You started your collegiate career studying physics. What turned you toward finance?
What you learn about electrons in the lab doesn't translate well into helping you understand the people in your life. I wanted to understand people, organizations, and the economy.
3. How would you describe smart beta in its simplest form?
Smart beta should be viewed as transparent, mechanical, index-based strategies, which provide well-known sources of equity returns, such as market exposure, contrarian value investing, low beta investing, and momentum investing.
4. Where does smart beta have its roots?
Without the success of traditional cap-weighted indexes, which made a strong case for index investing over active management, smart betas would not be experiencing the same embrace from investors.
5. What is the biggest misconception about smart beta?
Many investors want smart betas to be what they are not--they want smart betas to be top-quartile active managers who not only pick great stocks but also tell wonderful stock stories for every active position in the portfolio. Well-designed and honest smart betas are just not meant to replace active alpha strategies.
6. What also concerns you?
I am concerned that very complex quant strategies, which often look half data-mined and half voodoo finance, are now being promoted as smart betas.