Should you try to time the market with smart beta?

John Stepek

Smart beta is based on the idea that you can beat the market consistently using certain strategies or factors, that have been found to outperform over the long term (so far, at least). There are hundreds of factors these days (driven partly by demand from index providers for ideas for new products), but the number with significant academic weight behind them is far fewer. Among these are value (buying stuff that's cheap and avoiding stuff that's expensive) and momentum (buying stuff that's going up and avoiding stuff that is going down). Smart beta is becoming increasingly popular as investors look for ways to improve on existing market-cap weighted indices, and as a result, there's a lot of attention on the sector at the moment.

But of course, no investment strategy is perfect. Value and momentum might work over the long run. But they don't work all the time. There are periods during which each underperform the wider market. And these can sometimes be lengthy, even by the standards of that catch-all investment definition - the long term. For example, value investors have had a long and painful decade or so, with 'cheap' stocks lagging 'sexy' growth stocks badly.

It's also well known that investors have a tendency to chase performance. They have a bad habit of moving their money from underperforming funds to 'hot' ones - funds with a strong three-to-five year track record. They typically do this just in time for the 'hot' manager to turn cold, and for the one they've just fired to embark on a lasting recover. It's the opposite of buy low, sell high, and it's one big reason why the average private investor tends to underperform both the wider market and the average fund manager. These investors would be better off buying the dud managers and selling the outperformers.

Raging bulls

So it makes intuitive sense that taking a similarly contrarian attitude to smart beta funds should work too - investors should 'tilt' towards the out-of-favour factors, with the aim of benefiting from an eventual comeback, and avoid the ones that are popular. And indeed, that's the argument of one of the leading lights of smart beta and factor research - Rob Arnott of Research Affiliates. Arnott argues that factor timing is an issue that investors should consider very closely before they invest. Boiling down his argument (not easy to do in a small space, given the quantity of papers Research Affiliates has published on the topic), the apparent outperformance of many factors really comes down to "the strategy becoming more and more expensive relative to the market". As this continues, "the higher valuations create an added risk of mean reversion to historical valuation norms." In other words, if you buy a strategy when it's expensive, chances are that future returns will be disappointing.

Instead, you should invest in strategies after a period of underperformance (i.e. when the strategy is cheap relative to its own history). A September 2016 paper by Research Affiliates (titled 'Timing Smart Beta Strategies? Of Course! Buy Low') finds that "adopting factors or strategies with the best three-year performance produces the worst outcome across all time periods, while embracing factors and strategies with the worst three-year performance delivers the best outcome."

However, another leading light of smart beta - Cliff Asness of AQR - disagrees vigorously (and publicly) with Arnott. In effect, Asness argues that like any other form of market timing, factor timing is "deceptively difficult". A better approach, he feels is to diversify across factors. In other words, own a balanced mixture of 'value' and 'momentum' (and other factors) in your portfolio, rather than trying to choose winners. I have to say that my own instinct is that Arnott is correct about the difference market timing can make - if you get it right. But I also agree with Asness that for most investors, most of the time, it isn't worth worrying about factor timing - diversification and regular rebalancing make for a better approach.

Keep it simple, stupid

That's because one of the true advantages of 'passive' investing is that it encourages investors to think hard about their asset allocation at the start of the process, and then to be fairly hands off with their portfolios (beyond regular but infrequent reviews to rebalance). Few things can do more damage to the average person's long-term savings than the all-too-human craving to fiddle. Attempting to time the market is one of the classic ways to do a lot of damage to your portfolio and lose a lot of sleep in the process. So trading should be kept to a minimum in your portfolio.

As for the industry itself, there's also the problem that the idea of timing when to buy and sell factors introduces another layer of judgement into the investment process. Product providers like this as a theory, because it allows them to charge more for ETFs that promise to get the market timing right on the behalf of the investors. But paying more for something that increasingly resembles a return to the promises made by active management, doesn't strike me as a step forward for private investors. When in doubt, keep it simple - leaping from style to style is more likely to end in tears than to produce stellar returns.


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