“Nothing fails like success on Wall Street.” – Rick Ferri
I attended the Morningstar Conference conference in Chicago this week and listened to a great talk on smart beta and quantitative investing that included Rick Ferri of Portfolio Solutions.
Here are some of my notes on Ferri’s talk (not all are necessarily quotes):
- Smart beta strategies just had one of the best 15 year periods ever to backtest against cap weighted indexes. Any of these strategies are going to look magnificent against simple indexes when comparing performance numbers over this time frame.
- Many of the people touting smart beta don’t even understand what regular beta is.
- Smart beta has 3 disadvantages:
(1) The cost of beta is basically free (after netting out expenses with securities lending practices). Anything other than beta is more costly so there’s a hurdle rate. These hurdle rates can vary depending on the fund choice so choose wisely.
(2) There is always more risk in smart beta. There’s really no such thing as smart beta, just additional betas and risk.
(3) There are very long periods of underperformance with these strategies. Small cap value underperformed for 18 years in the 80s and 90s. The question is: Can you hang on? Unless you thoroughly understand it there is huge capitulation risk.
- Small & value strategies have been working very well since the late-1990s. What is the risk premium going forward net of costs? It’s much lower now than it was in 1999 so it’s possible you might not make up those costs going forward over the next 15 years. Of course, if that happened you could probably expect the following 15 years to work once again. This is how the emotions of investors work to make the markets function in cycles.
- Ferri’s concern is that if you haven’t been in smart beta is now really the best time to pile in? Investors might be a little too late at this point in the cycle. If you plan on jumping in now, make sure you’re ready to be in for the rest of your life. You have to commit to it and stick with it over multiple cycles.
- Premiums in the market do exist but they come and they go. What is the supply of excess return in the market? Ferri says he doesn’t know (it’s an unanswerable question). But when everybody wants to do something, it’s not usually a good time to do it.
- Also, Ferrri touched on the robo-advisor craze. He thinks they’re great for advisors. Younger investors that are saving money, paying low fees and diversifying are going to need advice some day for the wealth they accumulate. They will make great clients for advisors eventually.
Ferri is one of the most levelheaded, common sense voices in the world of finance, so when he talks I pay attention.
Basically, as with all investments, know what you are getting yourself into. Understand the process and reasoning for investing in any strategy, whether it’s factor investing, index funds, active management, trading or anything in between.
Also, it’s important to realize that any style of investing can go through huge periods of over and underperformance. That means determining the correct allocation size of certain strategies within your portfolio and diversifying among investment classes.
These lessons apply for smart beta (or whatever you want to call it — factor investing, quant investing, etc.) or any style you include in an overall portfolio.
For more on the smart beta phenomenon, Tadas put together a panel of finance bloggers (myself included) at Abnormal Returns to give their thoughts on smart beta:
Finance Blogger Wisdom: Smart Beta Trends (Abnormal Returns)
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