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Getting Smart About So-Called Smart Beta

Impressive marketing claims and back-tests are no substitute for economic intuition.

Alex Bryan, 10/23/2013

Who wants to be average? While many investors recognize the importance of low costs, it can be unsatisfying to settle for the performance of the broad market, particularly in a low-return environment. That makes it relatively easy for fund sponsors to market strategy exchange-traded funds. These passive funds seek to improve upon traditional broad market-cap-weighted index funds, while retaining benefits, such as low costs, tax efficiency, and transparency. Some of these funds try to enhance returns, while others target different outcomes that investors care about, like low volatility or dividend income. But some may not be able to deliver on their promises. With the recent proliferation of strategy ETFs, it may seem daunting to distinguish between funds that have a good chance of doing what they say they will and those that just have a good marketing story. However, a solid framework can make it easier to draw this distinction.

Any good passive investment strategy should be backed by an extensive body of independent research, and have a decades-long record of success both in the United States and abroad. There are only a few strategies that meet these criteria: value, momentum, low volatility, quality, and to a lesser extent, tilting toward small-cap stocks. If an equity strategy fund does not harness one of these factors, it probably isn't worth investing in.

Factor Review 
The concept of value should be familiar to most investors. It describes the phenomenon where stocks that are trading at low valuations tend to outperform their more expensive counterparts over the long term. Some researchers argue that this return premium is compensation for risk. Value stocks tend to have dim growth prospects, lower-than-average profitability, and have often been struggling for years. Yet, investors may penalize these companies too much by extrapolating recent performance too far into the future. This might explain why value stocks have generated better risk-adjusted returns than the market over the long run. Dividend income and fundamental index strategies harness a flavor of the value effect.

Momentum is the tendency for recent performance to persist. Stocks that have recently had the best recent relative performance often continue to outperform over the short term, while those with poor relative performance continue to underperform. Behavioral finance researchers argue that this effect arises because investors tend to underreact to new information and pile onto a trade once a trend is established. While it is difficult to articulate a conventional risk-based explanation for momentum, this strategy does not work well when volatility spikes. It experienced its worst performance during the 2008 financial crisis and the Great Depression.

Stocks with low volatility have historically offered better risk-adjusted performance than their more volatile counterparts. This effect may occur because many institutional investors face leverage constraints but are compensated based on their performance relative to a benchmark. In order to boost their relative performance, these managers may overweight high beta stocks, pushing their prices above fair value. Investors may also overpay for volatile stocks that offer a small chance of a big payoff--much as they might purchase a lottery ticket. 

Quality is an opaque term, but it generally represents the effect where stocks of companies with high and stable profits have historically outperformed those with lower and less consistent profits. At first blush, that may seem contradictory to the value effect. Quality stocks tend to command higher valuations than their lower quality counterparts, but it appears that the market has historically underestimated the long-term persistence of quality stocks’ profits, which durable competitive advantages can protect. Dividend growth funds essentially capitalize on this quality effect.

That’s Great, But … 
Even though these strategies have worked well over the long term, they may underperform for years. For instance, over the trailing five years through September 2013, many value and momentum strategies, such as those Vanguard Value ETFVTV and AQR Momentum Index employ, have underperformed broad market-cap weighted alternatives. Therefore, it’s necessary to have conviction in the strategy, and a long investment horizon to profit from it. 

But even a long investment horizon may not be enough. After all, a strong long-run performance record is no guarantee that a strategy will continue to work in the future. A profitable strategy is more likely to persist when the underlying effect has an economically sound risk-based explanation, is difficult to arbitrage, or is created by institutional frictions. It’s not obvious that quality possesses any of these characteristics. Quality stocks tend to outperform during bad times, which makes quality a relatively low risk strategy that should be easy to arbitrage. Nor are there any apparent institutional frictions that might cause investors to underprice quality stocks. If anything, it might be reasonable to expect a bias toward these stocks. For instance, a fund manager may receive a lot less flak for holding Coca-Cola KOwhen it underperforms than being caught holding J.C. Penney JCP, especially if conditions there deteriorate further.

Alex Bryan is an ETF analyst with Morningstar.

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