First person: Is smart beta really smart?
Smart beta is widely used by investors and organisations worldwide, but how do these investment strategies actually perform? The Review columnist Anthony Hilton examines the evidence
Considering how much money is invested in smart beta strategies around the world, there is very little research into whether or not they work. The consultants selling the various products will, of course, make a convincing case that they do (as salesmen will), but the better test is whether they can find independent academics to agree.
However, this is a challenge. There is little to be gained by looking at smart beta over a short period of time, or in just one market, because the results are unlikely to be convincing. One needs to be able to match the different smart beta strategies over long periods of time, in different locations and in different conditions – and not many academics have access to sufficiently large data sets.
A second problem is that there is not just one form of smart beta; it comes in many guises. Conceptually, however, it is simple enough – you begin with the market index like any passive investor, and then you weight it to reflect what you think will make it perform slightly better than it would if left alone. There are all sorts of factors that can be used to provide this little bit extra – over 300 on some estimates – but the most commonly used are large or small capitalisation, value or growth, stocks showing momentum, or those paying high dividends. It is also possible to weight the portfolio with more than one factor; for example, a fund could be tilted towards only those small cap stocks that are also showing momentum, or it could be long of one factor but deliberately short of another.
While it is easy to visualise what smart beta managers are trying to do, one should not underestimate the difficulties of actually doing it. There are reasons why it has only recently emerged – it could not be carried out without modern computing power, because it often involves constant monitoring, trading and rebalancing. It is probably also true that it is only in a low return world that the small improvement over passive investing delivered by smart beta becomes attractive.
Investors cannot ignore the fact that smart beta is not smart all of the time
Smart beta may or may not be smart investing, but it is certainly smart marketing. According to Credit Suisse, more than $1tn has flowed out of active management and into passive investments in the US alone since the eruption of the 2008 financial crisis. Many exchange-traded funds embody the strategy – they have come from nothing 15 years ago to being the investment vehicle of choice for millions of private investors today.
Professionals are there, too. A survey of global asset managers conducted by Professors Elroy Dimson, Mike Staunton and Paul Marsh – the team behind the latest edition of the Credit Suisse Global investment returns yearbook, in which the analysis of smart beta performance was first published – suggests that 75% of pension funds are now using or actively evaluating smart beta.
Once they had run their selected smart beta strategies against their vast database, Dimson, Staunton and Marsh discovered that portfolios tilted by individual factors, or a combination of them, will behave differently from the market as a whole – and this is something investors cannot ignore. However, that can be a downward effect as well as up, and it does not always apply in all markets. Investors cannot ignore the fact that smart beta is not smart all of the time.
The professors showed this by plotting the most commonly used factors on a grid to grade performance since 2008. The trio found that a factor that drives performance one year may well fail to do much during the next. Thus, the low volatility factor delivered three years of top quintile performance, three years in the bottom quintile and four around the middle. The size factor delivered three years at the top, but only one year at the bottom, as did momentum, and value had one year at the top and five years at the bottom. Income never made it to the top, but was never at the bottom either – it spent all ten years in the middle three of the quintile bands, with a bias towards the lower.
Over periods of 50 years or more, the professors discovered similar uncertainty. All factors make a difference; most are generally benign, but there is an ever-present danger of factor reversal. For example, over 50 years value significantly outperforms growth, but there are periods when it turns painfully the other way, and that is when all but the most resolute clients get shaken out. Similarly, small caps significantly outperform large caps in a 50-year run, but there will be periods with durations of ten years or more where the opposite is the case.
Yet again it suggests that, when it comes to investment, there are no easy answers.