The discussion around Smart Beta gets more ridiculous by the day. This morning I read a highly entertaining bit of nonsense about how smart beta can be used for downside protection. I spit McGriddle crumbs and syrup all over my suit, so my friends at ETF.com owe me a new one.
Here’s a truth bomb about what Smart Beta can’t do for you. Live with it.
1. Make you rich
Reasonable people make investments with the goal of increasing their future purchasing power and making sure the money they’re saving today keeps pace with what they’ll spend tomorrow. Smart Beta indexing may or may not offer investors a way to increase their money at slightly higher rates of return vs a market-cap weighted index, but this is not a sure thing. Smart Beta, however, is just beta in the end. The returns it generates will be largely in-line with the returns of the asset class it seeks to represent, plus or minus a few percentage points. The difference, when annualized, could add up to a lot, but not enough to change your life. There’s no secret factor that’s going to give you Oprah money.
2. Protect your downside
If there is an economic downturn or a bear market or both, Smart Beta investments will not be able to offer a meaningful amount of downside protection. In fact, because Smart Beta typically involves weighting a portfolio more heavily toward smaller cap stocks or deep value stocks, the strategy could actually work against you in a downturn. Smaller cap stocks, while offering premium returns over the long term historically, can be more volatile than the S&P 500 when recession hits, because the underlying companies have less financial flexibility than their larger, more established brethren. Smart Beta strategies can also be susceptible to industry-specific risk when their valuation-screening leads them into sector concentration. Consider that banks and home builders were among the “cheapest” stocks on reported earnings and book values heading into the Great Financial Crisis of 2008. When those earnings and balance sheet assets evaporated overnight, the lower multiples did not do you any favors.
3. Keep your emotions in check
When crisis strikes, stock correlations shoot up and publicly traded shares become a commodity, with traders drawing little distinction between computer companies and drug companies and insurance companies. When there are forced sales happening across Wall Street, that which can be sold will be sold, regardless of fundamentals or any other nuance. Smart Beta strategies are every bit as susceptible as fully invested active managers or passive index products. Knowing that you are invested intelligently based on evidence and proven factors will not make the near-term drawdowns hurt any less.
4. Make you pretty or thin
Goldman Sachs, John Hancock and Fidelity Investments are three giant financial services companies that have only this year decided to jump into the Smart Beta pool with new fund roll-outs. Goldman is hilariously calling their version
“Strategic Beta” (sorry, “Active Beta”, even more absurd, Orwell is LOLing). This is all marketing nonsense. Research Affiliates’ Rob Arnott famously put every Smart Beta factor in the “factor zoo” to the test and discovered that they all worked better than cap-weighted indices, if given enough time. Then he tested the inverse of popular Smart Beta strategies and found that even these bizarro versions (highest valuation, lowest quality etc) beat the index! Smart Beta can be effective, if given decades to play out, but in any given year, it will be every bit as ugly as any other temporarily underperforming strategy. Last year, for example, the small cap premium was a negative number. GMO’s James Montier looked at the burgeoning Smart Beta scene in 2013 and concluded it was merely “old snake oil in new bottles.”
5. Give you a game-changing portfolio
Factor investing is at least as old as Graham and Dodd’s early treatises on stock selection from the 1930’s. Warren Buffett has been running a portfolio based on factor investing for 40 years, only he found his stocks manually as opposed to quantitatively. James O’Shaughnessy wrote the seminal factor investing book, What Works On Wall Street, in the 1990’s and has since revised it several times. Ironically, the popularity of factor tilts (Smart Beta ETFs are now a half-trillion dollar category) may be the strategy’s biggest risk – the premiums for premiums are being compressed now that everyone is betting on the same attributes to outperform. It would be very funny to see factor tilts stop working for a few years, followed by an exodus to whatever new fad comes along, followed by factor tilt outperformance once again. To paraphrase Jesse Livermore, there is nothing new in Wall Street. There can’t be because factor investing is as old as the hills. Whatever happens in the stock market today has happened before and will happen again. Investors have been trying to buy a dollar for 80 cents since the beginning of time.