Is smart beta a good idea?

by , 12th September 2018

FTSE 100 tracker funds have served me well over many years but I’ve become increasingly worried they may not serve me so well in the future. That’s why I’ve become more and more interested in smart beta.

My concern about FTSE 100 tracker funds is that they’ve become very concentrated in a few large stocks, and as this long bull run continues, these trackers are buying more and more shares in the most popular companies – the ones that are often the most over-valued.

The traditional alternative to passive funds is active funds where stocks are picked by highly paid City stock pickers. The two big problems with active funds are well known – management costs are high, and the performance is often disappointing. What’s more, the past performance of an active manager tells us nothing about how she will perform in future.

So smart beta fills a gap. There are no highly paid stock pickers; smart beta is passive. But the passive investment strategy isn’t built around the market caps of companies. Instead the funds follow a different investment strategy, often known as a factor. The strategy might be value – companies that are cheap on well-known metrics – or momentum – buying shares that have done well over the last week, month or year. Other factors include size, quality and low volatility.

How it works

In a recent ‘Big Call Radio Show’, ETFstream’s David Stevenson outlined how smart beta ETFs typically work. If you invested in a UK ‘low volatility’ ETF, you might find that you were invested in most of the companies in the FTSE 100, with just the most volatile companies in the Footsie being excluded. These might be mining companies which are typically more volatile than other shares. What’s more, the weightings might not be purely driven by the market caps of the companies.

Each smart beta fund follows an index created for the particular strategy. The rules on how the index is compiled will be clear and can’t be broken. That’s why smart beta investing is passive.

David also talked on the show about multi-factor investing. This is where a fund invests using several factor-based strategies. So you might have a fund that invests in both value and momentum, or possibly as many as five or six factors. The worry with multi-factor is that if you’re investing in all the factors, you’ll end up investing in the whole market. But David says that multi-factor is different from the whole market because you’ll normally find a few stocks are removed from the traditional index whether it’s the FTSE 100 or the S&P 500 in the US. Even with multi-factor, you won’t invest in all the stocks in a flagship market-cap based index.

Cyclical

I also spoke to Nicolas Samaran of Invesco in the podcast and he pointed out that the different factors often perform best at different stages of the market cycle. If you’re investing on a time scale of three years or less, picking an individual factor may be the way to go.

If a market crash is pretty much at bottom, quality may work best, according to Samaran. (Quality companies often combine growing profits with a strong balance sheet. They may also deliver good returns on capital that’s been invested in the business.)

Value works well when markets are firmly rising from the bottom whereas momentum does well when markets are strong and ebullient. Samaran wasn’t sure where we are in the current market. He’s not sure whether Trump’s sabre-rattling will kill the current bull market.

If you’re investing on a time scale longer than three years, Samaran thinks that multi-factor is the best approach. That said, investors need to be careful and dig into the details of how the fund’s underlying multi-factor index is assembled. There’s no consensus across the industry on how multi-factor strategies should be implemented, so different multi-factor indices may perform very differently.

The case against

Not everyone is convinced about smart beta though. Richard Wiggins, a market strategist, is one of the sceptics. He told me ‘there’s a big question mark over the maths here.’

The problem is that researchers are looking at past data and looking for patterns to see if their favoured theory or factor works. The researchers are ‘p-hacking’ –  running the p-test too many times until they find something that seems to work.

‘But it won’t be predictive, it’ll just be garbage…the p-test was designed to be in a single test environment. You’re supposed to say ahead of time what’s going to work and why.’

Now, in fairness, there are smart beta funds that have been running for a few years now, and using their data is absolutely fine. We all know what the fund was hoping to achieve from the beginning. But if you’re data mining to support a factor, Wiggins thinks we should be careful.

You can read an article by Wiggins himself which gives more detail on why he thinks smart beta is ‘a fraud.’ The article is in the first edition of ‘Beyond beta’ – a new magazine looking at the world of smart beta in more detail.

As for me, I’m still open to the idea of Smart beta. I’ve invested in two value smart beta ETFs and I’ve done that for two reasons. Firstly, commentators such as Ben Graham have been arguing for a value strategy going back to the 30s, and they’ve been proved right over the very long term. There’s no data mining there. Secondly, value stocks appear to be relatively cheap compared to history.

I’ll keep an eye on the other factors and multi-factor too. As smart beta funds build a longer track record, there will be more and more solid data coming year after year.

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