Smart Beta bingo!

Ok you know my starting point – the majority of the financial services industry is little more than a bunch of smooth talking, well dressed bullshit artists selling snake oil at anything up to 2&20 (the common term used to identify the ultimate performance bullshitters – hedge fund managers). If we were remaking a Western, the fund salesman would be the nattily dressed guy on a soapbox selling the latest cure for all the ailments known to man. So when the marketing wizzes, sitting in their Herman Miller chairs draw up their latest Powerpoint deck, they’re always looking for a fancy name or strap line to snare the unsuspecting, the gullible and the all too trusting. After all I’m buying a product from a mega bank what could possibly go wrong? Smart Beta is just one such term.

Can Smart Beta get you in trouble?

It has become the term used to describe what many for years knew as ‘factor’ investing. An approach which focuses on various return factors that academia has identified over the years which can help describe where the returns from a particular investment come from. Examples would include whether the size of a particularly company (its market capitalisation) whether it is a growth or a value stock, it’s profitability etc. Indeed when you include these factors into performance calculations it quickly becomes evident that a supposedly successful fund manager’s track record has less to do with his skill (alpha — which is mostly luck masquerading as skill anyway – just ask any fund manager to tell you how lucky he is and expect an embarrased laugh) in picking investments and more to do with the exposure to various factors within his fund. So the fund industry being nothing if not efficient at latching on to a money maker set up a whole raft of funds trying to take advantage of theses factors and has, I’ll admit on the whole, done a pretty decent job of it. After all security selection for these funds is straight forward, it can be done largely mathematically and thus is cost efficient so these funds are usually far cheaper than your average mutual fund (therein lies part of the secret – a cheap fund is likely to deliver better performance than an expensive one – time for Homer Simpson- DOH!). The problem has been that the fund industry as usual has been pushing funds with those factors that have done well – can we all say performance chasing? This issue was highlighted by Rob Arnot of Research Affiliates – an innovator and deep thinker in the world of investing – when he wrote a paper entitled ‘Can Smart Beta get you in trouble?’

Rob was not attacking in and of itself the idea of factor investing but highlighting the potential issues of seeing it as being a sure fire way to great performance. Ok at this point I’m going to declare our hand. We’ve been converts to the idea of factor investing for many years, starting back in 2004 so it’s nothing new. One of the things that we learnt when we were first introduced to it was not to expect to see ‘outperformance’ from any particular factor year in and year out. Academic studies showed that based on what we have seen historically that over time one should expect to see overall outperformance from exposure to certain factors such as small cap and value stocks but that these factors can have long periods of underperformance, as with the value factor in recent years.

So are these factors really that ’smart’?

Not in my opinion. The academics who identified them are – in fact they’re some of the smartest finance minds around but these factors just are! They may give you periods of underperformance, they may give you periods of outperformance and on balance the evidence would suggest that over time you will get performance over and above what you would have had if you hadn’t have weighted your portfolio towards them. When are you going to get the outperformance? I haven’t a bloody clue and nor does anyone else. If they suggest they have they are a charlatan and a liar – take your money and run. Like anything they are something to take into account when taking a science based approach to constructing a portfolio but don’t bet the proverbial ranch on them because you might end up feeling like a bit of an idiot and not many of them are very ‘smart’ are they?

By: Richard Stott, Founding Partner, Connectum

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