I have been doing a fairly deep study of portfolio construction for the past two years, trying to figure out how to solve some of the most perplexing problems of the day: dealing with risk, volatility, performance chasing, and the ever-elusive challenge of actually figuring out where to find performance. One of the hottest topics in the literature and at conferences I attend is the concept of “smart beta.”
Smart beta is a rather elusive term in modern finance. It lacks a strict definition and is also sometimes known as advanced beta, alternative beta, or strategy indices. According to Investopedia,
Smart beta typically defines a set of investment strategies that emphasize the use of alternative index construction rules rather than simply using traditional market capitalization-based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as the need to enhance risk-adjusted returns above those of cap-weighted indices.
It certainly helps the popularity of smart beta ETFs and mutual funds that many of them have been on a performance tear of late. A lot of money is flowing into smart beta ETFs. At the end of the day, when I look at smart beta, it is really just another way to slice and dice the return stream in a particular portfolio. Thus you can have smart beta value funds, smart beta growth funds, smart beta momentum funds, smart beta…. There are literally multiple hundreds of smart beta funds available now.
I bring this subject up because I am at Rob Arnott’s Research Affiliates conference in Southern California (where it is much cooler than I expected). Between presentations by Nobel laureates and assorted academics, Rob offered a paper called “Can Smart Beta Get You in Trouble?” He has graciously given me permission to use a version of his much longer (and more dense paper) as this week’s Outside the Box. In the paper he examines exactly where the performance of many of the smart beta funds come from and then asks the question, “Will it persist?” Kind of like everyone is doing as they look at the latest bull market rally and wonder how long it can last. How long will the good times continue to roll?
The first version of Rob’s paper generated quite a bit of controversy, as it was interpreted by some in the industry as Rob attacking all smart beta products. These people are being oversensitive – perhaps because the overvalued products he writes about are the ones they sell? Rob’s own Fundamental Indexes are a form of smart beta. He is just suggesting that we do a deep dive into any product we are thinking about investing in and perform what analysts call “attribution analysis.” If there has been outperformance, why did it happen and is it likely to persist? Are there attributes of the product that are not fully valued – or that are overvalued? And if you can do that sort of analysis, then I think you can maybe look at smart beta products that have massively underperformed and find some value nuggets here and there.
Rob has won more CFA Institute Graham & Dodd Scroll Awards than just about anyone (except some guy named Myron Scholes), which is kind of like getting an Oscar for financial analysis. I have been told that he actually told the group to stop considering his papers so that other people could win. He really is one of the smartest people in the room. I always learn something new and often mind-bending when I’m around him. His paper is not long, and it will cause you to think about where the returns come from in your portfolio. You really should read it.
Speaking of mind-bending, economics professor Cam Harvey of Duke University did a presentation this afternoon on the blockchain, which is the foundation of Bitcoin. I have been friends with Cam for many years, but it has been an online friendship. He was the first to do research and analysis of the inverted yield curve, and I’ve learned a great deal from talking and writing with him. It was a true pleasure to meet him in person this week. He actually teaches a course on blockchain technology and is probably the most knowledgeable person I’ve met on the topic. As he began to expand on the literally hundreds of ways to use this technology in our everyday lives, you could see the room come alive with questions. It was a very energizing session.
(As I have written and talked about, I think Bitcoin as a currency will fail in its current version. It has some inherent flaws in its construction. The blockchain identity technology, on the other hand, is fabulously important and one of the most fundamental new ideas to come along in years.)
Cam came over when the day session finished, and we began to talk about some aspects of blockchain technology. Harry Markowitz, the Nobel Prize laureate who created Modern Portfolio Theory, walked over; and after a few minutes he began to challenge Cam on the mathematical impossibility of what he thought Cam was talking about. It was fascinating watching these two genius professors talk about math and ideas, and eventually Harry got a handle on the process Cam was describing.
But I will confess a small pleasure at watching one of the greatest mathematical economists of our time wrestle with the concept of the blockchain. I have to tell you it took me a while to get my head around the concept, too, and it took Harry only five minutes. (It took me days.) Once you really grasp the blockchain, you can understand why hundreds of millions of dollars of venture capital has gone into the technology from some of the smartest VCs on the planet, and why every major bank in the world is working on some aspect of it. You are not going to wake up one morning and find your world suddenly transformed, but blockchain is going to change the workings of a myriad of financial as well as nonfinancial transactions, including the transfer of property. And yes, it will eventually change the process of how money itself works. It is a truly profound concept.
Harry was in his usual affable mood, and we sat for the better part of an hour talking about the world in general and me listening to Harry tell stories. He tells such great stories. As we slowly walked back to the room (he is 88 but still make sure to walk for 30 minutes to an hour a day), he tried to explain diversification, covariance and correlation, and why Modern Portfolio Theory will still be relevant 62 years from now. (It has been 62 years since he presented his paper establishing Modern Portfolio Theory.) Sometimes you just get to bask in the moment – walking by the ocean, taking in the phenomenal view, and realizing that I was walking with history. It doesn’t get much better than this.
You have a great week. I think I’ll just go ahead and hit the send button and wander over to the reception and see what other great moments emerge in my immediate future. You just gotta love life.
Your not necessarily the smartest beta in the room analyst,
John Mauldin, Editor
Outside the Box
Can “Smart Beta” Get You in Trouble?
By Rob Arnott, Research Affiliates
“Buy low, sell high” is easy to say and very hard to do. Emotion encourages us to hang on too long to past winners (or even buy more, far too late and far too high) and to find every excuse to avoid bargains. Bargains don’t exist in the absence of fear, and always give us plenty of reasons to shun them. We’re reluctant to sell investments that have given us joy and profit, and even more loath to buy investments that have delivered recent pain and losses. Of course, it’s easy to avoid the pain and the losses, and still buy low … all we have to do is to buy at the exact bottom! As that’s not possible for mere mortals, buying low forces us to suffer the ignominy of losses – on investments that are already loathed – until the market turns.
Of course, capitalization-weighted indexes are natural performance-chasing strategies. We wind up with peak exposure in any stock, sector, style or even country, at the top of a bubble, and minimal exposure at the bottom of a crash. It was this intuition that led us to create the Fundamental Index concept over a decade ago. We use fundamental measures of a company’s economic footprint in the economy, as an economically-meaningful anchor to contratrade against the market’s most extreme bets. In so doing, we sever the link between a stock’s price and its weight in the portfolio. No longer does indexing require us to favor whatever are the most popular and expensive stocks.
One of our proudest achievements in launching the Fundamental Index® concept is that we helped to open the door to a wide spectrum of interesting ideas, under the “Smart Beta” umbrella. Since then, so-called Smart Beta strategies are all the rage in institutional and, increasingly, in retail investment circles. And, why not?! Most of these products are sensible and systematic investment strategies, offered at low fees, ensuring that any performance benefit goes mainly to the end-investor, instead of being siphoned-off by a money manager. Ideally, investing in these disciplined strategies can help investors avoid costly investment mistakes, including the popularity-chasing inherent in traditional cap-weighted indexes.
So, why worry? Why worry, indeed?!?
Investors, money managers and academia all look to past performance, to validate the thesis behind any smart beta strategy. If the past performance of a strategy is a sign of structural alpha systematically generated by the strategy, as vendors and their customers surely hope, then this is a great outcome! If rosy past performance comes as a result of strategy becoming loved, popular and newly expensive, then watch out! The first smart beta strategies sought to cure (even to contratrade against) performance-chasing, a behavior that is back, ironically facilitated and encouraged by a new class of smart beta beauties. This beauty parade, that brings the strategies with the best recent performance to the investor’s attention, is likely to hurt investors in the future in two ways.
First, any investor who buys a strategy with an impressive recent history expects continued success. If the rosy historical backtest came from the strategy doubling in price, relative to the broader market, it needs to double again just to match the past returns. Unfortunately, trees don’t grow to the sky. The history of the capital markets is not kind to those that rely upon soaring valuations as the basis for their future success.
Second, investors lose on the transaction costs from trading. Smart beta strategies aren’t a cure-all to consistent and reliable short-term outperformance. Their impressive long-term returns come with a fair amount of cyclicality. Each category of “smart beta” will go through thrilling periods of “buy now!” performance, giving way to periods of “what was I thinking?” results. For the performance-chaser, selling the latter and buying the former is likely to result in a substantial trading cost – a direct non-recoverable expense from investor’s wallet – with no long-term benefits to show for it (or worse).
When we examine the smart beta strategies and equity factors most commonly used today we see an alarming picture. We find that many of today’s popular smart beta strategies earned most of their historical performance by becoming more expensive. Sometimes over 100% of both long-term and short term performance advantage, relative to the market, is due to these strategies becoming expensive!
Figure 1 shows the recent 10 year performance of four commonly used equity “factors,” or sources of excess return, that are popular foundations for today’s smart beta strategies. These strategies typically are crafted as “long” the stocks with the desired attribute, and “short” the stocks with the undesirable opposite characteristic (e.g. long value stocks and short growth stocks). Profits are earned on the difference between the two porfolios.
In Figure 1, the blue bars are the annual returns for a long/short portfolio in each of the categories. Investors with a short memory (or following an asset manager with a short backtest) would conclude that value investing has become a fool’s errand and that investing in the most profitable companies is the way to beat the market. However, investors should pay even more attention to the orange bars. Value stocks have underperformed only because they have become cheaper and cheaper, and are now trading at a deep discount relative to growth. Meanwhile gross profitability can attribute its success solely to becoming expensive.
Figure 2 offers a different perspective. Over the full sample from 1967-2015, gross profitability had much more modest returns, all of which came over the last decade, and all of which can be attributed to rising valuations. Value investing, on the other hand, showed positive returns in spite of a decrease in valuation over this period, and spite of its abysmal recent decade.
Many of these strategies are expensive today, relative to their past valuations. Indeed when we check the current valuations we find that today five out of these six strategies are expensive relative to their own histories. The Low Beta/Low Volatility strategies have become very popular in the last fifteen years, after the tech bubble burst and the global financial crisis. This popularity brought about massive in-flows and expensive current valuations. We cannot know whether the rising valuations created the demand for these strategies, or rising popularity created the higher valuations. Either way, new investors in these strategies may be in for a rude surprise.
Given that soaring valuations drove the performance, in the Low Beta/Low Volatility category, we know that past returns are a completely unrealistic anchor to form our expectations. Worse, the high current valuations create a headwind for future returns. The same observation applies for the Profitability strategies, attracting billions each month; they appear to derive almost all of their past success from rising valuations and appear to be quite expensive today relative to their history.
The notable exception is Value. Value strategies have underperformed Growth by a wide margin over the last decade; that underperformance has come from falling relative valuations. Of course, this recent underperformance means that investors are fleeing value-tilted strategies, in favor of the more popular (and expensive) smart beta strategies with soaring recent returns. The good news is that this has results in current bargains for the Value investor, and therefore high future expected returns, for the few who can manage to ignore the temptation of the beauty contest.
When investors buy smart beta strategies with impressive recent performance, they make two mistakes. They set unrealistic expectations, based on artificially inflated recent performance. And, they set themselves up for awful future results, as valuations mean-revert towards historical norms. And they incur needless trading costs swapping from recent losers (now cheap) to recent winners (now expensive). Doesn’t this sound awfully like the mistakes that investors have made for decades with traditional active management?!?
Watch out … lots of “smart beta” customers, and vendors, are about to feel awfully stupid.