It’s indexing, but not passive.
Some call the approach smart beta, others say factor investing. Morningstar’s preferred term is strategic beta. Whatever the label, the tactic of buying securities that have a particular feature or group of features—such as trading at a low price/book ratio or having high price momentum— has become very popular. Those who buy such funds believe that they own better betas. Their funds will beat the market.
That, of course, is the promise of active management. Strategic-beta investing is active management. Because they are typically offered through exchange-traded funds that mimic indexes, strategic-beta strategies tend to be thought of as passive investments. They are not. They make active decisions, with the promise of delivering outperformance, and should be evaluated accordingly. For both strategic-beta investors and traditional active managers, there are three key questions:
The strategic-beta strategy must be supported by reason. There must be some credible explanation why that particular beta—or collection of betas—is superior. The justification could be economically based and rational, or it could be behavioral. Or it could be both.
Value stocks, for example, are said to carry higher risks than their standard deviations would suggest, because they are particularly vulnerable to economic recessions. Therefore, they compensate with higher returns. They also are supported on behavioral grounds, with the argument that they deliver better performance because they are psychologically difficult to hold.
Suffice it to say that for strategic beta, as with other forms of active management, everything flows from why. If there is no satisfactory answer to that question, then those pretty back-tested numbers likely came by accident. The data were mined until they yielded something shiny and yellow—but fool’s gold it was.
Assume that a strategic beta can be defended. One can understand why it delivered good investment results in the past. That explanation is a necessary condition for the strategy’s future success. It is not, however, a sufficient condition. For one, the economics may have changed. Consider again value stocks, which (according to some) carry a return premium that compensates for their tendency to crater along with the general economy. Perhaps that occurred because the value-stock indexes held many cyclical companies. If the composition of the value universe were to change, then that argument might no longer hold.
The point is, each strategic beta is correlated with many other factors. As those correlations change over time, the performance premiums will also shift. The economics behind each strategic beta are not static.
Nor, of course, are investor beliefs. Despite the best efforts of investment bloggers and business-school professors, behavioral biases are unlikely to change. We can lecture incessantly about buying when blood is running in the streets, but when the blood actually is running, most investors are likely to flee. In my view, strategic betas that depend upon behavioral explanations are unlikely to lose their entire justifications.