Typing “Smart Beta” into Google yields sixty-four million hits. Close to the top of the list is the headline “Smart Beta – The Investing Buzzword that Won’t – and Needn’t – Die”. For every advocate there is a cynic such as GMO’s James Montier who coined the equation “Smart Beta = Dumb Beta + Smart Marketing”. Montier observes that many of these ETFs seek to capture a premium attributed to one of two factors; Value and Size.
So, let’s be clear, most strategies labelled as Smart Beta, are in truth portfolios designed to capture the returns from a particular factor of which Value, Size, Momentum and Quality are the most well-known. Investment strategies targeting one or more of these factors are not new. Wells Fargo’s investment business became a leader in passive equity investment between 1975 and 1990 when it merged with Nikko Investment Advisors and developed factor tilt portfolios that became a staple product of Barclays Global Investors (BGI) which was the business created by the purchase of Wells Fargo Nikko Investment Advisors by Barclays PLC in 1995. BGI spawned iShares and was subsequently subsumed by BlackRock. Meanwhile State Street Global Investors, Goldman Sachs Asset Management and many more specialist asset managers, of which BGI was the leader, met a seemingly insatiable demand for low-tracking error, quantitatively implemented portfolios that delivered, according to back-tests, the holy grail of benchmark plus 2%. Marketing materials talked about high levels of diversification. But were they? Almost without exception these strategies combined value, size, quality and momentum and some added a bit of leverage. The result was inevitable – too much money chasing the same stocks – and what become known as the quant crash of August 2007, triggered by the unwinding of a leveraged multi-factor portfolio.
Smart Beta Exchange Traded Products allow all investors to chase these factors.
Why are factors so attractive? From the investor’s perspective, the act of committing capital requires the assessment of uncertainties and the application of probabilities to make decisions. Uncertainty makes humans uncomfortable. If science or academia can offer us certainty, we believe we will sleep better, convinced we have found a free lunch. From the scientist’s perspective, the equity market provides an almost infinite quantity of his favourite food – data. And if tortured enough, this data will reveal powerful secrets which may well support prior beliefs. Fama and French told us about Size and Value in 1993, at the same time Jagadeesh & Titman showed us the power of momentum and then received support from Hong and Stein in 1999. The work of Piotroski in 2000 found that “quality” is another route to equity investment success. The work of Grinold and Kahn in 1995 (the orchestrators of BGI) demonstrated how this work could be pulled together to deliver investment success. Their book is seminal reading for all quantitatively oriented investors. This work appeared to offer certainty.
This certainty is dangerous. Blindly following a factor based strategy will lead investors into the same companies as others following the same factors – and there will be many as the research papers reside in the public domain as academics must be published to achieve peer review. This was observed in August 2007 when a leveraged factor portfolio, allegedly run by Goldman Sachs, was unwound and triggered a wave of selling across all similar “smart beta” portfolios which unwound years of carefully nurtured “alpha”.
Two days ago, we were sent some marketing documents for an Equity Risk Premia Beta Neutralised Portfolio. It is available in both UCITS compliant OEIC form or as an ETF. All the investor is asked for is their choice of leverage – will sir be taking 3x or 5x today?
Here we go again………