Is Smartβeta so smart after all? Guy Dobson, director of NZ- and UK-based investment consulting and education firm, Dynamique, says investors should check the smarter data before making dumb moves
Great news for Smartβeta followers, according to ETFdb.com, two of the most successful Smartβeta ETFs as regards attracting new monies in 2015 were WisdomTree Europe Hedged Equity Fund and Deutsche X-Trackers MSCI EAFE Hedged Equity. Each pulled in over US$10 billion.
The increasing appeal of Smartβeta ETFs helped iShares overtake Vanguard in total fund inflows. As in life, good news often comes tainted with some downsides.
One of the pioneers of Smart-βeta, Rob Arnott, chairman and CEO of US firm Research Affiliates, commented that this hugely popular investment strategy could result in investors being disappointed over the three- to five-year period. Research Affiliates developed some of the world’s first Smartβeta strategies.
In a recently released report Arnott cited the following key points why the risk flags are beginning to wave:
- Factor returns, net of changes in valuation levels are much lower than recent performance suggests;
- Value-add can be structural, and thus reliably repeatable or situational- a product of rising valuations – likely to be neither sustainable nor repeatable;
- Many investors are performance chasers who in pushing prices higher create valuation levels that inflate past performance, reduce potential future performance and amplify the risk of mean reversion to historical valuation norms; and,
- There is the reasonable probability of a Smartβeta crash as a consequence of soaring popularity of factor-tilt strategies
The rising valuation levels of securities, industry sectors, asset classes or strategies inflate past performance, create an illusion of superiority, reduce the future return prospects and pose a risk of mean reversion to historical norms. This is the tendency for market rates and ratios to go back to their past values. When the rise in valuation level is stripped out focusing purely on true performance the results are some pretty depressing numbers.
For the 10-year period from Q3/2005 to Q3/2015 the Factor Return Decomposition return covering Value, Momentum, Small cap, Illiquidity, Low βeta and Gross Profitability ranged from Gross Profitability of 4.54% to Value at -4.44%. Ouch!
For the same period the Smart Beta Strategy Return Decomposition leader of Quality Index yielded a miserly 2.37% with the lowest being Fundamental Index at 0.48%.
In the report’s conclusion, Arnott and Berstein observe that “the investment management industry thrives on the expedient of forecasting the future by extrapolating the past”. For past performance to be used appropriately in investment statements the data should cover several generational economic cycles. Cherry-picking positive return data to fit marketing expediency can mislead investors.
The tsunami of assets flowing into such strategies creates headaches for managers. Many investment ideas may fail to perform as expected once asset prices reach a certain level of valuation and fund growth exceeds the tipping point of strategy optimum performance.
The world is awash with global liquidity chasing yield. Therein, of course, lays the dilemma. At what point does strategy performance decline and start to disappoint investors?
Furthermore, newly-launched Smartβeta funds may be a reincarnation of a current poorly-performing fund – a Lazarus in new clothes. Professional investors are watching the Smartβeta evolving story with great interest, cautiously hoping that firms promoting such products and attracting an increasing flow of funds have thoroughly back-tested such strategies to ensure their absolute robustness.
-Arnott & Berstein (2002) p64)
-IPE EDHEC Scientific Beta Research Insights Autumn 2015
-Fundamentals Research Affiliates Feb 2016. How can “Smart Beta” Go Horribly Wrong?