Smart Beta Strategies: Beyond The Hype

THROUGH THE LOOKING GLASS

In brief, smart beta strategies aim to capture higher market premiums by tweaking the rules of passive investing. They depart from market capitalization, the cornerstone of index weighting, and instead follow weighting rules that select for other factors such as sales, cash flow and dividends, relative volatility and momentum. Once the rules are set, smart beta strategies are managed passively.

Management fees tend to be low and transparency is high. And the way these funds are marketed can be compelling. They presume market mispricing, and many claim to reduce volatility while delivering the expected returns of a traditional passively-managed portfolio.

So you may be nodding your head and thinking, “That sounds great!” But think before you jump. The core principles of passive investing are built on many decades of empirical financial research demonstrating market, size and value premiums. The basis of smart beta strategies is built on a similar platform, but with twists that may over- or under-expose investors to these factors or have other implementation shortfalls. Let’s take a closer look at some of the potential hazards.

THE PERIL OF IGNORING PRICES

Research has proven that the price at which a security is trading is the best indicator of a company’s current value. Price is also the variable that is most often refreshed. For example, if we discover that behind the scenes VW is putting the fix into their emission systems, that information is probably going to be reflected in tomorrow’s stock price—but not in last quarter’s book value, cash flow or dividend information.

Ignoring prices is unwise, because expected returns depend on the profit investors expect to receive as well as the price they pay. Bottom line: breaking the link between a security’s price and portfolio weight can have a big impact on a portfolio’s future performance.

MOMENTUM LOADINGS AND PERFORMANCE

Now let’s take a look at momentum investing. Generally speaking, momentum strategies rank securities based on relative absolute performance. Once stocks are ranked, indexes are constructed from securities exhibiting the strongest momentum according to their market capitalization.

The momentum factor offers one of the largest premiums seen in equity markets. But there’s a downside: momentum tends to decay quickly, which requires turnover averaging 200% or more with very high transaction costs. Data shows that when costs of capturing the premium are taken into account, and controlling for drivers of return premiums that we already know how to capture, there’s no evidence that momentum strategies generate outsized returns.

LOW VOLATILITY: VALUE IN DISGUISE?

Now let’s consider low volatility strategies, which underweight the most volatile (high beta) and overweight the least volatile (low beta) securities. This weighting scheme is based on the perception that high volatile securities are overpriced and low volatile securities are underpriced.

Low volatility strategies are growing in popularity in part because the equity roller coaster has been so turbulent over the past decade. Investors are more mindful of the risk in their portfolios and how much they can really stomach. Plus, over the past four decades low volatility strategies have performed impressively, delivering market-like returns with much lower volatility than the market.

But here’s a question…if beta (risk) is related to returns, then why is lower beta not penalizing returns? All else constant, lower beta should be associated with lower returns, right? The explanation is that over the last four decades, low volatility strategies have not just had lower market beta, they’ve had higher exposure to the value premium. This has offset the return difference you would expect with lower market beta, enabling these strategies to keep pace with the market return while offering lower volatility.

Will the pattern persist? While it has held steady over the past four decades, the first thirty or forty years of equity returns in the United States were different. During that time, low volatility securities did not have the same emphasis on the value premium, and their returns were commensurately lower.

In brief, smart beta strategies aim to capture higher market premiums by tweaking the rules of passive investing. They depart from market capitalization, the cornerstone of index weighting, and instead follow weighting rules that select for other factors such as sales, cash flow and dividends, relative volatility and momentum. Once the rules are set, smart beta strategies are managed passively.

A more sensible strategy might be to pair equity investing with an allocation to fixed income. Aim for your higher expected returns with an emphasis on small caps, low relative price and high profitability stocks, while reducing volatility with fixed income investing.

WHAT SMART INVESTORS SHOULD CONSIDER

With more smart beta strategies being introduced every day, the truly smart strategy is to know what’s driving your returns. Is it new or something old in disguise? Well-understood drivers of expected returns can easily explain the historical performance of fundamental and low volatility strategies.

What’s not well understood is that smart beta strategies may inadvertently expose investors to high-return securities that have not been explicitly targeted. This limits results to back tested environments that may not be reliable. Simulated historical returns should raise eyebrows even more when the strategy comes with high implementation costs, such as for momentum strategies, which can chew up expected benefits.

In sum, complexity, hidden risks and higher costs should make investors wary. So should slick, clever marketing that promises outstanding results with very low risk. In truth, the great majority of investors will be better off taking a simpler, historically proven approach to investing with a portfolio of low cost index funds matched to their objectives and risk tolerance.

As for Cardiff Park, our advice remains unchanged. Adopt a sound strategy, tailor your asset allocation to your risk tolerance and investment objectives, diversify broadly, set realistic expectations, maintain a long-term perspective and keep your costs down. That’s the truly smart way to make money.