How Smart Is Smart Beta?

"Smart beta" is all the rage among the smart set. Recently, a French research firm presented in Chicago on the topic the same day that AQR, a money manager with University of Chicago Ph.D. connections, visited Morningstar to discuss the very same subject. Just one day before, BlackRock announced that it was launching a series of "smart beta" exchange-traded funds.

To translate: Beta is financial academese that means "risk factor," for which an investor is (allegedly) paid. The U.S. stock market has a beta, as do Japanese bonds. "Smart" means that the beta, or risk factor, is not associated with a standard market, but rather from another source. It also implies that this beta is a particularly good one to own. The premium that comes from holding value stocks is an example of a smart beta. So, too, are the extra returns associated with owning illiquid stocks or from owning securities in less-developed countries.

I'm not crazy about the jargon; it's the sort of thing that makes my wife clap her hands over her ears and mutter, "Thank God I don't have your job." But the concept of smart beta is helpful for investors. Effectively, it means lower expense ratios. Because portfolio activity that once was regarded as active management, and which commanded the fees of active management, is increasingly being redefined by the notion of smart beta as a version of passive management. This means that costs for value strategies, or momentum strategies, or low-liquidity strategies, or perhaps value +  momentum + low-liquidity strategies, are heading lower.

In summary, yes, smart beta is quite the smart idea. Any theory that leads to investments becoming cheaper has much to recommend it.

Yesterday's News
The New York Stock Exchange has petitioned the SEC to force investment managers to report their holdings much more quickly.

The petition does not involve mutual fund holdings per se but rather a money manager's entire book of business--that is, all its funds, all its separate accounts, all that it owns. Under Rule 13(f) of the Securities Act of 1934, investment advisors with at least $100 million in assets (hmmm, that amount needs updating) must file quarterly reports that list their aggregate investment holdings. As the rule was adopted in 1975, it permits money managers a lag of up to 45 days to double-check the abacus before reporting their holdings. The NYSE requests that this 45-day period be slashed to two days.

Predictably, money managers are not pleased. (The day that the investment-management industry welcomes additional disclosure will be a cold, cold day in a very warm place.) Vanguard and the Investment Company Institute (the fund industry's trade organization) argue against the petition on the grounds that publishing this data with such a short lag will permit "free riders" to anticipate the trades that the big investment managers are making and to profit from such knowledge by front-running those trades.

To which I respond, hmmm. When mutual funds were required to publish quarterly rather than semiannual reports, there were similar mutterings. No damage seems to have been done. More dramatically, PIMCO very gingerly releases its holdings for its flagship mutual fund,  PIMCO Total Return (PTTRX), waiting until the final days of the permitted 60-day lag for mutual fund reports. Meanwhile, PIMCO continually publishes live and complete holdings for its ETF version of Total Return ( PIMCO Total Return ETF (BOND)) without apparent damage. PIMCO Total Return is outlegging both the index and competitors this year, and the ETF version is faring even better.

I suspect that this wolf will not come, either.

For Safety, Consider Stocks
A couple of weeks back,  Fairholme Focused Income (FOCIX) had a very pleasant day. Priced in the morning with a net asset value of $9.90, the fund gained $1.10 on the day to finish at $11 even in price and a daily total return of 11.11%. Three years' worth of bond-fund gains in a single day!

The story: At last report (Feb. 28), the high-yield bond fund had an astonishing 40%+ of its assets in the bonds from a single company, MBIA. The evening before the fund's gain, news broke that MBIA had reached a legal agreement with Bank of America, a company with which it had wrangled for several years in the aftermath of the 2008 financial crisis. (MBIA, a bond insurer, had paid out several billion dollars' worth of claims on bonds issued by B of A and was none too happy with how B of A had represented those securities to MBIA when B of A came seeking MBIA's insurance feature.) MBIA's stock promptly surged 40%, and its deeply high-yield bonds were not far behind.

One moral of the story: Die with Bruce Berkowitz, live with Bruce Berkowitz. Fairholme Focused Income had putrid relative performance in 2011 and 2012 as it rode MBIA on the way down. Anybody with a watchlist mentality would have dumped the fund before its May 2013 rebound. As with Fairholme's flagship stock fund, (extreme) patience is required for the Focused Income Fund.

The other moral: Yes, under certain circumstances bond funds can be more dangerous than stock funds. When trafficking in higher-risk sectors such as high-yield or emerging markets and when concentrated as with this Focused fund, a specialized bond fund has the potential to be riskier than a relatively tame, diversified, blue-chip equity fund. It doesn't happen often, but it can occur.

The same evening that the MBIA news was released, TNT basketball analyst Charles Barkley said that the injury-plagued Chicago Bulls had "no chance" of winning its first playoff game against the defending champion, Miami Heat. Barkley repeated the assertion. "No chance."

Chicago, as you may know, won the game (although not the series). It did indeed have a chance.

Well, that's what analysts do--state a viewpoint as reality, a probability as a certainty. Whether in sports, economics, or, yes, investments, audiences don't seek shades of gray. (Stop right now, that's not what I meant.) They want the experts to be decisive. So, the experts comply.

When I worked as a fund analyst, I did my best to determine how deeply a fund manager believed his own bravado. Managers are trained to appear as omniscient, so I was happy to shrug off the mere act of overconfidence. That was no flaw; that was giving the audience what it wanted. But the reality was another matter altogether. That was a big bright warning sign. Good decisions come from admitting nuance, from admitting the possibility of failure.

Charles Barkley? I think he's faking it all the way.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.