Edition: April 2016/ June 2016
Editorials

INVESTMENT STRATEGIES

How smart is smart beta?

It can be, but not necessarily always. Doubts arise with burgeoning popularity.

Since March 2011, all JSE-listed companies have ostensibly been required to publish an integrated annual report or to explain why they haven’t. Although this has proved to be nothing more than a soft ‘expectation’ that the JSE by its own admission (rather surprisingly) has not sought to push, SA companies have nevertheless been leading the way globally in publishing annual integrated reports.

For pension funds around the world, the popularity of ‘smart beta’ as an investment strategy has grown in leaps and bounds. Morningstar, the data provider, reckons these assets under management have ballooned from $103bn in 2008 to $616bn in 2015.

Why so? Basically, because they’re considered to be a halfway house between lower-cost passive investment and higher-cost active management. They’re intended to adapt passive strategies for above-market returns by, for instance, excluding stocks that have shown the most volatility in previous periods.

A new-born sceptic is Rob Arnott, chairman and chief executive of Research Affiliates, the US company that developed some of the world’s first smart-beta indices. He warns in the Financial Times that the soaring popularity of these indices could lead to a severe fall in investment performance: “In the next three to five years I expect that some smart-beta investors will end up very disappointed.”

Research Affiliates recently published a report suggesting that some smart-beta funds could go “horribly wrong”. It found that many smart-beta strategies had outperformed the market because their underlying stocks had become more expensive, not because of the factors that the indices claimed to have generated outperformance.

According to Arnott, chasing performance rather than investing fundamentally could have dire consequences: “If you buy what has gone up, just because it has gone up, you are buying for reasons that have nothing to do with valuations and run the risk of buying into a bubble.”

David Stevenson, an FT columnist, also has words of caution. He he’s found that smart-beta vehicles can look cheap, but passive investing often involves lots of active trading to accord with index-weighting changes. Also, internationally, he’s worried that there are now more smart-beta indices than there are large-cap stocks: “Many of the more esoteric smart-beta ideas simply aren’t scalable and you’ll soon find your returns eaten up by front-running.”

His advice:

  • Stick with existing fund managers who run quantitative strategies that are in turn offered in an EFT (exchange-traded fund) wrapper. These managers will have to justify it when their strategy doesn’t work and will also have a sense of fiduciary responsibility;
  • Experienced fund-management groups, which have been using quant ideas for decades, are best at blending the different strategies into one final EFT product;
  • Investors jump onto dividend-weighted indices because of generous yields. But a high yield might actually signal a market in distress;
  • Keep an eye on costs. Understand what goes inside the index (a difficult task), then consider sector-trackers and EFTs as real alternatives. They’re popular with hedge-fund managers because they’re an easily-understood cost-effective way to play big trends in say defensive stocks (utilities), growth stocks (tech) or even quality businesses (consumer stocks).
Smart beta explained
Variety of smart beta Why you might buy it What to be careful about
Minimum or low volatility Exclude or minimise those stocks with most
volatility over previous periods. Good at
avoiding most obviously cyclical stocks and
an easy way to buy into defensive stocks if
markets are a bit skittish.
May end up being very sector focused
(utilities). Probably underperforms in a bull
market.
Equal weighted Rather than weight stocks by market cap, equal weight all of them. Makes mid and small-caps more important. Great news in bullish markets. In bearish markets likely to be much more volatile (all those riskier smaller stocks).
Value of fundamental weighted Weight stocks by their ‘cheapness’ or underlying ‘value’ i.e more profitable, financially sound, boring businesses are more important. Value stocks in past have outperformed. Value stocks have underperformed over many years. Can end up being expensive in fees. Not the same as buying a very active stock picking fund manager.
Quality Buy shares in businesses with decent balance sheets, paying a decent dividend and decent earnings growth prospects. A supposedly safer way of playing long term equity growth. Everyone might think quality stocks are a great idea and make them expensive.
Dividend Buy more shares in businesses paying an above average dividend yield. A good way of compounding growth over long term from all those dividend cheques. Could be focused on a few key market sectors such as banks (well, before 2008) paying chunky yield. Also stocks may be high yielding because market has decided they’re terrible investment ideas.
Momentum Buy shares with strong positive momentum i.e performing better than the wider market. Brilliant idea in bullish markets. Lots of transactions and turnover. Could end up being expensive in trading costs. Terrible idea in depressed markets.
Size or small-cap Buy shares in businesses with smaller market cap. Brilliant idea in bullish markets. Likely to be much more volatile than boring mega caps. Terrible idea in depressed markets.
Multi factor Buy lots of different strategies above in one fund or structure. Cost effective way of investing, avoiding the most obviously volatile shares. Sensible, boring, strategy for pointy head types. Boring. Depends on the ‘mix’ of strategies. If you get the wrong mix may as well just buy a simple broad passive vehicle. The ‘cook’ doing the blending of recipes needs to be very experienced with a great record.
Source: David Stevenson/Financial Times