Smart beta makes a great deal of sense for mainstream investors, with many variants of factor investing producing outperformance over the long run. But it’s not a risk-free trade. As a form of quantitative investing, its vulnerable to a number of headwinds. It’s certainly true that most smart beta strategies are very transparent but that doesn’t mean that the users understand why the ‘factor’ works when it does. Knowledge doesn’t necessarily automatically flow from transparency – you need to know what to look at first!
Investors also need to be aware of the risks of data mining and the high likelihood that a risk premium will begin to fade as soon as it becomes investable. Overtrading is another less obvious risk. A few years ago, for instance, Andrew Lapthorne at French bank SocGen released an excellent paper which looked at how varying smart beta strategies resulted in overtrading. The net result? Transactions increase substantially, as do costs and investors might find returns lagging behind as a result over long periods of time.
In these circumstances, investors considering using smart beta need to tread carefully. Luckily though there have been a number of studies in recent years which have provided some useful clues about what investors should watch out for. Let’s start with that paper by Lapthorne and colleagues at SocGen. They concluded their study on over trading with some sage advice for investors contemplating using smart beta funds:
Transatlantic fund management group Invesco also issued a gaggle of academic research papers a few years back by researchers at Cass Business School (the City University London), with one in particular of direct relevance – it’s called ‘Smart beta: Monitoring Challenges.’
The authors are Prof Andrew Clare, Prof.Stephen Thomas and Dr Nick Motson and they draw together a vast wealth of literature to answer what is increasingly the most important question – what should be looking for in picking the right smart beta product? Whereas with active fund managers we need to worry about the personality of the investor, in smart beta we need to focus on the index itself. Put simply a badly constructed and maintained index – and accompanying ETF – could destroy your wealth.
The Cass academics argue that “investors will need to be certain that the ‘production’ of the index is of a very high standard and that all the rules are laid out clearly in the published description of the index”. The main international association of securities commissions, IOSCO, has suggested that investors should focus on issues such as how the index is governed, benchmark quality, detail of methodology and accountability. “Before investing in a smart beta fund investors might wish to check that the index provider is committed to the high index production standards laid out in the IOSCO paper” suggest the academics. More importantly looking at the ETF investors need to satisfy themselves that the manager has the operational skills and capabilities to replicate the smart beta strategy in an efficient manner.
Not to be outdone, US analysts at research firm Morningstar have also been tracking the rise of these smart beta funds and they’ve developed their own checklist of factors to watch out for. Some of the language is a bit ‘challenging’ for the ordinary investor, nevertheless it is worth a read.
Here’s Morningstar’s own check list for using smart beta products – they reckon as an investor you should evaluate the following:
What does this fund do?
Find out which index it tracks and read the methodology document.
Does this fund attempt to leverage a well-known factor?
What does the fund own?
Style box characteristics
Quality and profitability
Are there other funds that offer similar exposure?
How does the fund’s expense ratio and portfolio compare?
Has the fund performed as expected? – look at peer group relative performance
What are the risks?
These varied studies into smart beta and its efficacy allow us to compile what I think is an essential checklist for smart beta investors – what I call a due diligence list of potential smart beta snags:
Find out more about the index and how it has performed in various markets in the past. Crucially investors need live and after cost daily performance numbers for any smart beta index. If the index provider does give this information, avoid it!
Also consider using this performance data to look at how much the index changes in composition terms every month or quarter i,e. examine how the index ‘turns-over’ on a regular basis.
Ask whether there is any independent research available on the ideas behind the smart beta index i.e. white papers and research notes.
How much extra in terms of fees – in basis points – are you paying for the index construction? A range of between say a few basis points and 0.20% seems reasonable but anything much above 0.40% needs some explaining.
Understand the index rules and explore any white papers that give a deeper, research-based understanding.
Look at the investment debate and see whether particular styles of investing – value or growth – for instance are becoming more popular. Not every investment style (expressed in a smart beta index) works all the time. Quite the contrary in fact – some investment styles such as value investing can underperform for many years
See how concentrated the index is in individual stocks. One index might contain only 50 stocks, another 500. One is not better than the other but you do need to understand how your index is built and how concentrated the holdings are
Be aware of how much turnover there is in the index and what the likely impact of trading costs will be on performance
Is the smart beta index a genuinely independent, third-party creation? On a related theme see if there’s any independent academic evidence – or research cited – that backs up the central insight of the index
Closely examine any white papers or background guides which explain the thinking behind the smart beta strategy and which explore past performance
Be cautious about smart beta back tests. In my experience, any data of this kind has limited value unless the back test goes back over many decades.
Transparency matters. More than a few smart beta indices are built on black box approaches where the key investment metrics are not revealed.
Monitor your smart beta picks carefully. The Cass academics note previous research amongst professional investors which suggests that 38% of respondents said that they were reviewing their clients’ smart beta investments on a monthly basis; 45% on a quarterly basis; 13% every six months.