I’m a fan of smart beta, but picking the factors you want to invest in isn’t easy.
One widely followed approach is to look at where we are in the economic cycle and then invest in a factor or factors that normally do well at that point. So if the economy is strong and we’re firmly in ‘expansion’ mode, you might go for momentum, value or size. But if the economy is slowing down, you might want to put your money in low volatility on the basis. That’s because ‘low vol’ shares supposedly won’t suffer as much in a downturn,
However, Rob Arnott of Research Affiliates, widely known as the ‘godfather of smart beta’, doesn’t think that’s the way to go. The danger of mechanically going into low vol when the economy is slowing is that you might overpay for your shares. Arnott argues that you must focus on valuations when you pick your factor tilts for your portfolio.
So if you’re trying to evaluate the value factor, you need to look at the valuation of value compared to, say, growth. Value will almost certainly be trading on a lower multiple than growth, but you need to look at the size of value’s discount compared to growth. Then you compare the current discount with historical numbers.
Arnott’s data suggests that you can generate strong performance by investing in factors that are relatively cheap at the time of your investment. It’s a better approach than focusing on where we are in the cycle or looking at past performance according to Arnott.
And Arnott is clear that value is the place to be right now. Arnott told the Inside ETF conference in Florida today: ‘value is cheap all over the world and extremely cheap in emerging markets.’ He was saying much the same thing in London last October.
Conventional wisdom says that now is a bad time to invest in value when we may be close to the top of a boom. That’s because companies that are in difficulties may struggle more in bad times and you may see big sell -offs by investors. That’s the theory anyway, but Arnott’s research suggests that you shouldn’t focus on the cycle – valuation is what counts.
Arnott added an extra twist to his current positive stance on value. He said that investors can use momentum signals to ensure that they don’t buy a value stock when it’s still in freefall. In other words, momentum may help you avoid a value trap. You can read more about this way to use momentum in a Research Affiliates paper: ‘Can Momentum Investing be saved?’
You can also find the latest relative valuations for the different factors at the Smart Beta Interactive website.