The growth of smart beta investing seems unstoppable. Over the last three years, the amount of money invested in 'systematic beta' strategies has doubled to $1 trillion, and the money is spread across 2200 investment strategies, according to MJ Hudson Allenbridge. That's pretty striking growth, but that doesn't mean that smart beta is the investment elixir. It's not flawless.
If you're not familiar with Smart beta, it covers passive investment strategies, and indices, that aren't driven by market cap. So a fund that invested equal amounts in all 100 constituents of the FTSE 100 index would be an 'equal weight' smart beta fund. There's a raft of other smart beta strategies or 'factors' out there including value, momentum and quality. I explain smart beta in more detail in Smart beta basics.
Systematic beta is a broader term because it includes long/short strategies whereas smart beta only includes long-only strategies.
The big attraction of smart beta is that it offers investors the chance of beating the market at a relatively low price. Traditional market-cap driven passive investing is normally cheap - sometimes as low as 0.05% a year, but, by definition, it can't beat the market. Smart beta funds normally have higher charges, but not that much higher.
Fans of smart beta argue that it means private investors can get access to investment strategies that have previously only been used by high-charging hedge funds.
Smart beta is also transparent and rules-based. You might put money into a fund where the stocks are picked by a successful value manager. But there's no guarantee that he won't drift away from a value strategy at some point. What's more, it might be a while before wealth managers and journalists spotted what the fund manager had done.
There are downsides though. One is that smart beta often doesn't work. As John Stepek highlighted for ETFstream, research by Antti Suhonen, a finance professor at Aalto University in Finland, suggested that the theoretical outperformance a 'new' factor dropped by nearly 75% when it was used as part of a live smart beta approach. In other words, there's a big danger of overly clever data-mining. If you look hard enough, you can find complex strategies that have worked over the last ten or twenty years, but often they don't carry on working. Too clever by half.
That's why I think that if you are going to go for a smart beta strategy, it makes sense to go for a relatively simple one which you understand.
Another problem is that with 2200 available strategies, the choice is so huge. And even within a strategy or factor, there's still huge variety in what you may end up investing in. Let's look at two leading US value ETFs as example. The iShares Edge MSCI USA Value Factor UCITS ETF and the SPDR MSCI USA Value Weighted UCITS ETF. They sound similar and as they're passive funds, you might think their portfolios would be similar or identical. But that's not the case. Look at the top 5 holdings for each fund:
SPDR MSCI USA Value Weighted UCITS ETF - top 5 holdings
Company% of ETFJP Morgan Chase3.1Apple3.09Bank of America2.55Citigroup2.4Wells Fargo2.19
IShares Edge MSCI USA Value Factor UCITS ETF
Company% of ETFApple9.99General Motors3.44Pfizer3.39Intel3.18Wal Mart3.13
Looking at the above 'top 5' holdings, it's pretty obvious that the ETFs are pretty different. So if you're going to invest in a value ETF, you need to dig deep and find out what particular strategy and index is being followed. Yes, smart beta ETFs offer transparency but investors need to take advantage of that transparency and do some research.
A paper by US firm, Research Affiliates, on growth investing illustrates the point too. The paper suggests that successful growth investing strategies shouldn't focus on the companies that are investing the most. Often these companies over-invest and deliver poor earnings growth in the future. Instead Research Affiliates argues that the best growth investments are in firms that generate strong returns on investments - returns on equity. These firms tend to have sizeable 'moats' which make it hard for rivals to come in and steal market share.
Research Affiliates cites Coca-Cola and Kellogg's as examples of successful growth stocks whilst Yahoo and Compaq are cited as failures. The story of Compaq is especially striking. In the 90s it was the largest manufacturer of PCs and it spent aggressively on acquisitions. These takeovers didn't produce the expected economies of scale while the rapid expansion caused quality control problems. The returns on these investments were pitiful.
The point is, an ETF that invested in companies with high levels of investment could have easily ended up with a big stake in Compaq in the 90s. Research Affiliates claims its growth strategy focuses on the stocks that have years of sustainable growth ahead of them.
Don't get me wrong, I don't hate smart beta. I have money in three smart beta ETFs. I'm just aware that it has downsides as well as strengths.