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Inside the Market GMO’s James Montier takes issue with equal-weighted indexes

A dealer points to a chart showing the FTSE performance in the past week on a screen on the trading floor of IG Index in London May 6, 2010.

Kevin Coombs/Reuters

The highly respected James Montier at global asset manager GMO wonders why investors continue to fall for the "stories offered up by investment managers/alchemists." Among them: The infatuation with so-called smart beta, or exchange-traded funds that are devised to beat major benchmark indexes, such as the S&P 500.

Some do this by ignoring the traditional method of weighting stocks and instead give each stock an equal weighting. Others take a more sophisticated approach, weighting stocks based on things like profitability. (I wrote about this subject before, here.)

Either way, Mr. Montier is not impressed: Smart beta, he says, is dumb beta plus smart marketing. Ouch.

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But he doesn't take issue with recent performance – the S&P 500 equal weighted index has outperformed the S&P 500 by an astounding 30 percentage points over the past five years and 5 percentage points over the past year, after factoring in dividends – but rather in the way these smart-beta approaches work. That is, they tilt towards value stocks and small cap stocks, and Mr. Montier doesn't like it one bit.

"In other words, the fact that smart beta has outperformed has nothing to do with the story told...it is simply that they embed exposure to value and small, two traits known to have outperformed over time," he said in a white paper released on Thursday.

"Of course, investment managers have worked out that turning up at someone's door and saying, 'I've got this brilliant idea about how to beat the cap weighted benchmark. I'm going to invest in value stocks and small cap stocks!' would get them laughed out of town. But make no mistake about it: that is exactly what just about every smart beta strategy is doing."

Okay, but there are other investment strategies that are very simple, if that is his issue here. Dividend investing isn't much more complex than, well, buying stocks with dividends, and that approach has worked well.

Indeed, Mr. Montier's biggest complaint appears to be that now just isn't a good time to load up on value stocks and small cap stocks, given that GMO's forecast calls for "unattractive expected returns" in the United States. But the same holds true for all U.S. stocks at this point, making smart-beta look no worse than traditional indexes.

Despite his efforts, smart beta actually comes out looking pretty good.

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