We have to hope smart beta is not another example of dumb alpha

The financial services industry has spent hundreds of years perfecting new and exciting ways of separating investors from their money.

It typically starts with the realisation by someone - David Swensen, chief investment officer at Yale University, for example - that there is a different way to invest. Whether by luck or judgment, that method works; Swensen bought hard-to-trade assets and invested heavily in private equity - ideal for the boom years. Early copiers also make money, and soon the industry develops products to take advantage.

What became known as the "Yale model" resulted in a flood of money heading to second-rate private equity companies as the industry expanded, while fund managers created Yale model funds to collect money from wealthy individuals keen to copy Swensen.

Yale did brilliantly from the approach, but eventually it was doomed to the same boom-bust cycle as any other popular style, as too much money flooded in and valued scarce assets too highly.

Sashaying down the catwalk towards investors is the latest financial services fashion, under the name of "smart beta", "scientific beta" or "strategic beta". Money has poured into exchange traded funds taking the approach, which now encompasses more than $500bn, on some estimates.

The idea is simple enough. Much of the return from a high-fee stock-picker fund comes not from selecting the best of any given sector - Shell against BP, for example - but from being broadly overweight smaller companies, or low-risk companies, or from capturing trends, or even simply avoiding weighting by market value. Each approach has been used to great effect by investors who were early to adopt them, notably Warren Buffett.

The latest pitch is that these returns are available on the cheap. Rather than paying 1 per cent a year or more to an active manager, construct your own portfolio from cheap trackers of "smart beta" models. Those selling the products wield impressive sheaves of academic evidence about their past success. They can also explain why they work: the foibles of investors.

Momentum strategies, which buy shares that are going up and sell those that are dropping, work because investors tend to follow the herd. Buying into unpopular "value" stocks works because investors tend to get overly depressed about companies that do badly, pushing down the price further than is justified. Boring, low-volatility stocks outperform over time because fund managers prefer exciting companies that might beat the market over a short period, meaning the dull shares are cheaper than they should be - one way Buffett beat the market for so long. (There are competing explanations, too.)

If too much money starts chasing these strategies, they will stop working or, worse, lead latecomers into disasters of the sort experienced by those who adopted the Yale model in 2007. On the other hand, early entrants should profit handsomely if the anomalies are eliminated, as shares discounted due to behavioural issues rise to values justified by their fundamental risks.

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He accepts smart beta has become a big talking point among pension funds and large institutional investors. But he argues the money invested so far remains relatively small compared with the overall market.

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One question investors can usefully ask is who they are making money from. To beat the market ("generating alpha" in industry jargon) with smart beta, there must be investors who will underperform. This could be the traditional fund managers who, after all, typically fail to match the market on average, or it could be private investors, big institutions or hedge funds.

If money comes from existing passive managers, smart beta returns will be eroded. But if money is moved from active managers to smart beta, investors will be paying lower fees while still exposed to the factors behind many good funds' performance.

It would be rash to forecast the failure of strategies that have worked, albeit with long fallow periods, for many decades. On the other hand, smart beta is clearly moving into the mainstream, making the past less useful as a guide to future returns. Buyers have to hope the hype is ahead of its true popularity, and smart beta is not merely another example of dumb alpha.

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What James is thinking . . .

The argument for shares has mutated from talk of economic recovery and rising profit margins into a claim that shares are, if not a bargain, less overpriced than bonds. But this leaves shareholders vulnerable to any correction in the bond market.

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