How Smart is Smart Beta?

Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha
Jan 14, 2020 12:50:20 PM 4 min read

Investments in “smart beta” products remain popular, and this is likely the inevitable result of an evolution of investing that began half a century ago. “Markets are efficient so you cannot expect to outperform” was the refrain coming from the ivory towers of academia. Around the 1970s came index investing, making investors an appealing promise: At least you won’t lag the market.  

But as academics continued to find flaws in their asset pricing models and market efficiency in general, an interesting consequence was the identification of certain factors that seem to boost returns. As this became more widely appreciated, investors grew bored with market-matching returns and a new innovation surfaced -- “Smart beta.” A clever name but a bit misleading; smart beta can be quite dumb.

What is smart beta? 

To understand smart beta, consider the S&P 500. This is a market-cap-weighted index, meaning the stocks that are the largest get the most weight. But imagine an S&P 500 ETF or an S&P 500 index fund that claims to beat its benchmark by simply re-weighting the components of the index. Perhaps stocks deemed to be the cheapest on the basis of a ratio, such as book value of equity to market value of equity (book-to-market), are given more weight regardless of how the S&P 500 weights them. If stocks with a high book-to-market ratio tend to outperform those with a low book-to-market ratio, the portfolio weighted in this way should tend to outperform its market-cap-weighted benchmark. This is the concept behind smart beta, or factor investing. 

Factor investing is an intriguing idea. There are indeed certain factors such as size and value that have been robustly shown to lead to higher average returns. The keyword is average. Just like the market itself, these factors are far from reliable, and their robustness has been shown over many decades, not necessarily the time horizon investors are concerned with. All factors can experience long periods of under performance. So, an investor who has chosen a “value” portfolio, for example, might need to endure years of disappointing results before ever beating the broader market. This can be very frustrating.  

Expected returns and realized returns are often very different numbers

Consider the S&P 500 Value Index, which serves as the basis for smart beta products such as the iShares S&P 500 Value ETF. This index tracks the performance of value stocks, which according to theory, should be expected to outperform. Shown below is its performance compared to the S&P 500, the universe from which the index is formed. Value stocks have severely lagged the market.

naa_blog_smart beta_table-01-1Much has been written about the under performance of value stocks in the past ten years, with some commentators even going so far as to question the strategies of Warren Buffett. This seems a bit of a stretch. That simple metrics of a value approach such as price-to-earnings or price-to-book value haven’t yielded success does not imply that the value approach to investing is flawed. Indeed, this is a basic problem with factor investing. Using too few metrics to determine the merit of investing in a stock invites failure.

Even if the factors did work historically, after the proliferation of smart beta strategies, the factors could no longer work due to what amounts to a market-wide arbitrage. That is, if everyone believes that value stocks outperform, they will buy such stocks through smart beta funds, bidding up the prices of these stocks and eliminating any sort of return premium. 

Don’t give up on alpha!

Of course, it is far from certain that the mispricing of these factors will be arbitraged away. It is quite likely that many of the factors used to develop smart beta products will, over the very long run, contribute to out performance. But even if this is the case, the investor is not being adequately compensated for the risk of long periods of under performance.

A better way to approach the construction of a portfolio of funds is to supplement smart beta products with a product that reduces risk and evaluates a stock holistically. A product that assesses risk after consideration of many different factors, will have a return profile different than that of a simple smart beta product, with the added possibility of outperforming

There is still room in a portfolio of funds for smart beta, but that doesn’t rule out a product that possesses many of the positive attributes of smart beta such as diversification and programmatic stock selection. Take the human element out of the decision-making process, but by all means, don’t give up on alpha.

CC: NAA10025

Julian
Kern
Co-Written by Julian Koski, Co-Founder and Chief Investment Officer and Andy Kern, Senior Portfolio Manager