Investing in Smart Beta Explained
Smart Beta is becoming more and more popular. It is a way to invest where different shares are chosen based on certain characteristics associated with higher returns.
Though the origins of smart beta go way back, it was brought mainstream by esteemed professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth college through their Three Factor Model.
In summary, their research concluded value stocks out performed growth stocks and small-cap stocks out performed large-cap stocks.
This research triggered a couple of ideas. Firstly, the odd money manager who had managed to out perform the market had probably done so by buying value and small-cap stocks. Secondly, if anybody else wanted to beat the market all they needed to do was buy value and small-cap stocks.
But before you rush out and stick all your hard earned cash in a smart beta fund it is worth bearing in mind a few things.
Why history doesn’t matter
If there’s one thing we do know, it is that just because something happened in the past doesn’t mean it is going to happen in the future. Just because these smart beta strategies worked before doesn’t mean they will again.
You can slice up the market just about any which way you want and find that certain bits outperform others at certain times. No matter what the time period or the data, you can always split it down the middle 50/50. Without doubt 50% of the numbers will be better than the other 50%.
All you have to do is to come up with a reason why. Sometimes this reason might be valid, sometimes it might not.
Jack Bogle & reversion to the mean
There are many reasons for this. Jack Bogle, the founder of Vanguard, would point to reversion to the mean. That stock prices always have times when they under or over perform the wider market, but in the end they all average out. Maybe buying value stocks will work for a few years, but sooner or later they will under-perform.
Mr Bogle isn’t alone with his concern about reversion to the mean. Rob Arnott of Research Affiliates a global leader in smart beta has this to say:
Indeed our evidence suggests that mean reversion could wreak havoc in the world of smart beta. Many practitioners and their clients will not feel particularly “smart” if this forecast comes to pass.
Rob Arnott – Research Affiliates
Questionable data
Others would point out that the dataset any research is based upon is simply not reliable. It is not long enough or accurate enough. Maybe, the last few decades of data in places like the US and UK is up to scratch. However, data further back and for other countries maybe questionable.
At the end of the day, the economy has to have some influence on stock prices. Ray Dalio, in his book the Economic Machine, says a long term debt cycle typically lasts 50 to 75 years, so the data available probably covers one debt cycle at the most. Basing assumptions on one occurrence of something has to have its problems.
On top of this there is another argument that now these factors are known, their out-performance will be limited. If HSBC is cheap, everybody who wants to buy value is going to buy it, which in turn is going to push the price up.
OK, maybe the first few guys who bought it would do well, but even they need to be clear why they were able to buy it. Were the guys who sold it to them idiots?
Whose selling what you are buying?
That should be unlikely because 95% of trades are carried out by institutions. Whenever you buy something you are likely to have just bought it off an institution. Just think about the resourses all these pension funds, investment banks, and hedge funds have at their disposal.
But does this mean investing in smart beta isn’t going to work? Not necessarily. These special strategies may work, but at the same time they may not. From everything we know, if they are going to work, then they are likely to inflict pain along the way, because free lunches are hard to find in investing.
No pain no gain
That is to say, there are likely to be long periods of serious under-performance otherwise everybody would be investing in smart beta and if everybody invests in them they cannot work.
The pain needs to be long enough and deep enough to ensure the majority of investors and money managers don’t persevere through the bad times.
Maybe the money managers would be disciplined to stick with it themselves. However, knowing that their clients will pull their investments from funds that under-perform for a couple of years should be enough to prevent them from persevering for too long.
Dr. Fama himself says:
Whether you decide to tilt towards value depends on whether you are willing to bear the associated risk . . . The market portfolio is always efficient . . . For most people, the market portfolio is the most sensible decision.
Eugene Fama
Taking the risk of investing in smart beta may be suitable if you are super risk tolerant. Say, for somebody who is already 100% in stocks. Investing in smart beta strategies to try to get an additional boost may just be worth it, but for everybody else, why not just increase your stock allocation.
If you can stomach the severe drops in stock price now and again, most experts agree that simply increasing the amount of stocks in your portfolio is the most reliable way to improve your returns over the long term. For example, if you are 60/40 stocks to bonds, then increase to 70/30 or 80/20.
Investing in smart beta is betting against the market and that is a big call.
I think Jack Bogle summed it up best:
If you bet the market is efficient and hold the market portfolio, you’ll earn the market’s return. But if you bet against it and are wrong, the consequences could be painful. Why would you run the risk of losing, perhaps badly, when the market return, earned by so few over the long-run, is there for the taking?
Jack Bogle
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