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Ranking Smart Betas

Not all are equally bright.

John Rekenthaler, 10/03/2013

Is There a Risk Factor?
Michael Edesess has done what few have dared: He has trashed Dimensional Fund Advisors. As evidenced by the title of his book, The Big Investment Lie, Edesess enjoys poking objects with a sharp stick. However, it's one thing to jab at hedge funds, a rose that long ago lost its bloom. It's quite another to take on DFA, which has never been more popular, either in reputation or in sales.

And take on he does. In the provocatively titled article, "Why DFA's New Research is Flawed," which appears in the publication Advisor Perspectives, Edesess accuses DFA of practicing quackery. The company might appear to follow only the most rigorous scientific principles, writes Edesess, as befits its stable of PhDs, its connection with The University of Chicago, and its citations of Gene Fama and Ken French, but in reality it conducts "spurious pseudo-mathematical" analysis that leads to "poorly constructed and poorly presented nonsense." The company, states Edesess, "has succumbed to a dreadful descent into scientism."

I can't go quite that far, but I do agree with Edesess' central point: Many of today's so-called smart betas--defined here as alternative weighting schemes for market indexes--lack economic motivation. That is, researchers can examine historic security prices and determine that certain attributes are associated with better performance. Low-priced "value" stocks, for example, have generally outgained higher-priced "growth" stocks. What the researchers often fail to explain, though, is why this occurred. In the absence of such an explanation, the suspicion becomes that the research was an exercise in data mining.

As Edesess freely acknowledges, this critique is not specific to DFA. It applies to a wide variety of index weighting schemes that are derived from research findings, used by many investment companies. Edesess targets DFA's latest work, that corporate profitability is a smart beta--with companies that have high rates of profitability enjoying better long-term returns than those with medium or lower rates--so he focuses on DFA. This column, in contrast, does not concern a particular company, but instead addresses the more general topic of the reliability of smart betas. Can they be trusted? Will they repeat in the future?

The answer differs according to the beta. Some betas--or factors--are well grounded in economic and/or behavioral patterns. That is, they are associated with real risks, which is why they offer real and ongoing higher returns. Other betas, not so much. It's difficult to understand why they present a risk, and therefore why they present an investment opportunity.

My ranking of some of the better-known smart betas, from most likely to repeat to least are as follows: 

Liquidity--One of the newer smart betas, researched by, among others, Morningstar consultant Roger Ibbotson (who sold his company, Ibbotson Associates, to Morningstar several years back), liquidity is surely the most reliable of the bunch. The so-called liquidity premium actually means the opposite of what its name would seem to suggest; that is, it means accepting a loss of liquidity by investing in securities that are particularly difficult to trade. In exchange for forgoing the ability make easy, low-cost trades, the investor can and should receive higher returns.

Which indeed has been the case, per the research. I strongly expect that pattern to continue. Most investors prize liquidity, either out of necessity (because they may well need to make a trade on short notice), or for greater mental comfort. There may also be institutional mandates for a certain level of liquidity in professional managed portfolios. All these factors should make liquidity a winner going forward, for all manner of securities. (Even with a security as generic and frequently traded as a long Treasury bond, on-the-run Treasuries tend to yield less and thus return less than older, off-the-run issues.)

is vice president of research for Morningstar.

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