Rob Arnott from Research Affiliates caused a bit of a stir in the fund world a few weeks ago when he called for a potential crash in smart beta funds. Here were the main takeaways from his recent research paper:
1. Factor returns, net of changes in valuation levels, are much lower than recent performance suggests.
2. Value-add can be structural, and thus reliably repeatable, or situational—a product of rising valuations—likely neither sustainable nor repeatable.
3. 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.
4. We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies.
I agree with a few points he made here but not with the conclusion.
Something many investors don’t seem to realize is that smart beta is nothing new. It’s a form of investing that has been around for decades considering Benjamin Graham’s first book on value investing, Security Analysis, came out in 1934. Portfolio managers have been practicing many of these strategies for years, they just defined it differently. Smart beta is simply a rules-based strategy that looks to invest based on a single or set of risk factors. Off the top of my head I can come up with quality, low volatility, momentum, value, market cap and multi-factor funds that combine the different approaches.
The problem I have with Arnott’s conclusion is that he thinks a glut of smart beta funds and the ensuing performance chase that will happen to the best performing funds will cause a crash. I tend to think this is a bit alarmist.
Some context is needed.
Market crashes can occur because certain areas of the markets become too crowded (see the quant crash in 2007 as an example). But crashes are usually consistent with the use of leverage or concentrated positions. Historical factor crashes have mainly come with long/short strategies because when the tide turns you get hurt on both the long and the short side (think long cheap and short expensive or long high momentum and short low momentum strategies).
The majority of smart beta funds are broadly diversified and hold many hundreds or even thousands of different stocks. There is over $420 billion in smart beta funds, but that’s a drop in the bucket considering the global market cap of the world’s stock markets is something like $70 trillion. And that $420 billion is also spread across over 500 smart beta strategies. Smart beta funds aren’t the only ones investing in these factors, but they certainly don’t control a big enough share of the market to cause a crash if and when investors decide to bail from these funds.
Of course, Arnott is right that too much money chasing the most recent outperforming funds can cause problems. Every strategy, no matter how disciplined its rules are, can become over-priced (or under-priced). It’s quite possible that this will cause higher than average volatility when there is a regime change in these factors. But that’s what happens to all successful investment strategies. Nothing works all the time and mean reversion always has to be taken into account.
Will there be underperformance in smart beta-type strategies? Of course. Higher volatility? Most likely. A smart beta crash? Not likely, unless the entire market crashes. It just doesn’t add up to me.
While were on the smart beta topic, here are a few things for investors in these funds to consider:
- You always have to understand what you own and why you own it. And “because it outperformed in the past” is not a valid reason.
- Be aware that concentration in any single factor, fund or strategy is bound to lead to disappointment eventually.
- Factors tend to work better when they are combined with one another because they provide a smoother ride for investors and offer the chance to rebalance into poor performers.
- If you aren’t willing to rebalance into a poor performing smart beta style you probably shouldn’t invest in them in the first place. They’ll all underperform at some point.
- Looking for outperformance in smart beta is less important to me than the diversification benefits. Assuming you can invest in this space and magically outperform is a recipe for disaster and performance chasing.
Smart beta ETFs offer a low-cost, tax-efficient, convenient fund structure that allows investors to gain exposure to different areas of the markets. Putting together one of these portfolios on your own in the past would have been nearly impossible, especially in such an efficient manner. They’re not perfect. They’re not going to save you when there’s a market crash. But you know exactly what you’re going to get when you own them. The problem is many investors go in with unrealistic expectations.
This is why I think that ETF-picking will replace stock-picking as a retail investor hobby in the future. Instead of chasing star mutual fund managers investors will chase the best-performing risk factors. But performance chasing is nothing new. There’s always a shiny new toy for investors to play with in the latest fad investment. I don’t think we’ll see a smart beta crash any time soon, but that doesn’t mean investors won’t hurt their portfolio returns trying to game these funds.
Smart beta isn’t a new invention, but neither is performance chasing.
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