Burton Malkiel has a new piece up on Wealthfront’s website calling smart beta strategies into question. It’s a very interesting and hot debate at the moment, and Malkiel’s perspective is worth a read—many of his points are important to consider.

The problem with this debate is that it is impossible to evaluate “smart beta” as an entire category relative to cap-weighted indexes, because smart beta strategies can be very different from one another. For example, a low volatility smart beta strategy will provide very different returns than a high momentum strategy. Any comparison between cap-weighted indexes and smart beta should be made on a strategy by strategy basis.

I think smart beta strategies should be assessed just like any strategy, and here I’ll lay out the criteria by which I think investment strategies should be evaluated. Hopefully you can use these criteria when making a decision between a smart beta strategy—or a traditional active strategy—and a traditional cap-weighted index.

Passive Investing—Misnamed, Misunderstood, and Flawed

First off, the debate between “passive” and “active” is misleading. As Cullen Roche recently pointed out in a post, everyone is active to some extent. Every strategy is an active bet that certain stock selection and weighting criteria are better than others.

Cap-weighting is itself a strategy that says “buy big stocks, the bigger the better.” Cap-weighted indexes are hard to beat because they are so cheap (and the fee differential between index funds and other strategies compounds over time) and the fact that rules-based cap-weighted indexes are inherently disciplined…they never deviate from their strategy. The goal of Smart Beta indexes/ETFs is to use the same discipline, but build indexes with better rules.

Malkiel’s best point is that costs (higher fees, taxes, and turnover) make some smart beta strategies inferior. But the piece, which denounces smart beta as a marketing tactic, is pretty light on empirical evidence. In a bit of cherry picking, Malkiel invokes the example of RAFI indexes taking on more risk in 2009 by overweighting bank stocks (which worked for RAFI), but leaves out the similar risky bets taken by cap-weighted indexes, like the massive weight to tech stocks in 2000 (which didn’t work for the S&P 500). Oh, and RAFI would have worked in the tech wreck, too, because fundamental indexes would have been very underweight the tech stocks that were producing very little sales/earnings/cash flows/dividends.

Evaluating Any Investment Strategy

Given that any investment strategy is active to some extent, I think there is a small list of important criteria when choosing where to put your money—whether it is indexing, smart beta/indexing, or traditional active. There are four main criteria worth considering.

#1 – Strategy consistency

Is the strategy rules based (and therefore consistent) or not? Consistency is very important for long-term success. Indexes—and Smart Beta—have this in their favor. The S&P 500 “strategy” has never changed, so it has consistency baked in. Non-index managers are less consistent. According to this recent SPIVA report. over the past five years, just 46% of funds stayed consistent to their style. Switching strategies/styles at the right time is very hard to do.

Bottom line: consistent approaches are better.

#2 – Selection Criteria

Rules-based is good, but the rules themselves are very important too.

I spend a few chapters on this topic in my book. but the bottom line is that market cap is a convenient but sub-par weighting/selection criteria. Indexing is the right strategy for a lot of people and is a great basic way to own equities, but I also believe that the right kind of “smart” strategy will deliver superior results. Here’s one example why.

Imagine breaking up all of the investable stocks [i] in the U.S. market up into 10 equal groups (deciles) based on their market capitalizations. Decile 1 would have the 10% of companies with the biggest market caps, and decile 10 those with the smallest. Today, there are around 300 companies in each decile, and 3,000 investable stocks total. Then imagine doing the same thing every year back in time for the past 50 years.

The figure below illustrates how each size decile has performed relative to the equal weighted opportunity set. Not much information in the 8 smallest deciles, but the largest stocks have significantly lagged the equal-weighted market. In particular, the biggest group of stocks has lagged the equal weighted opportunity set by almost 2% per year. Here’s the problem: 78% of the weight of the S&P 500 is in this largest decile today. The top 50 stocks by market cap have done even worse historically.