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James Montier on Today's Investment Fashions

Montier snaps at smart beta and risk parity.

John Rekenthaler, 12/11/2013

(Maxwell) Smart Betas
James Montier of GMO's asset-allocation team (striking a blow against grade inflation, that appears to be his official title) is among the fund industry's top writers. He tackles important subjects, glides past the distracting details without oversimplifying, and knows his material. His letters are on my short list.

I quite enjoyed this month's paper, "No Silver Bullets in Investing (just old snake oil in new bottles)." In the article, Montier spanks two current investment trends, "smart beta" indexing and the "risk parity" approach of asset allocation. (As a bonus, he finishes with a brief but useful overview of how different assets tend to fare against inflation. I'll touch on that subject in tomorrow's column.)

His smart-beta argument is not new. As with several critics before him, including Morningstar's Paul Kaplan, Montier regards most smart-beta strategies--that is, indexing schemes that weight not by market capitalization but instead by some other process--as being value and/or small-company approaches in drag. Call itfundamental weighting, call it equal weighting, call it minimum variance, call it what you like. They all result in pushing a portfolio down and to the left in the equityMorningstar Style Box, away from large growth and toward small value.

This is clearly so, a fact that is openly acknowledged by one of smart beta's creators, Rob Arnott, who recently stated in a  Morningstar interview that "what's smart about smart beta is breaking the link with price." He continues, "equal weighting does much the same thing [as does Arnott's approach of fundamental investing]."

Developing the idea further, breaking the link with prices does more than put a fund into smaller companies that sell at lower price/book multiples. It also moves the portfolio more heavily into stocks that have cheaper share prices, that have lower trading volume, and that are priced more cheaply relative to their companies' sales. That is, the portfolio gains not one, but five "smart betas": small company, value, low-priced stock, illiquidity, and fundamentals. (Actually, it gains more betas than that, but we'll stop at five for this discussion.)

These betas are related. Having more of one beta implies having more of all others. What remains to be determined is how to disentangle the effects. To the extent that smart beta works, what are the factors that drive that success? Do some of these factors count for more than others? Such research is in its early stage and hasn't yet yielded much insight, aside from the fact that the value factor seems to be more important than the small-company attribute. At this stage, the key lies not in the details but rather in the decision. Market weight to get traditional beta. Break from price to get "smart" beta.

There are two notable exceptions to the extended family--smart betas that appear to be unrelated. One is stock-price momentum, first documented in academic papers in the 1990s. Momentum is not related to small/value betas. The second is the newer idea of quality, which is variously defined, but which can be summarized as "company attributes that Warren Buffett would like." Examples would be high profitability, low debt, and stability of earnings. These are good things, rather than risks associated with the small/value spectrum. Whatever the payoff for quality--which is barely understood, the notion being so nascent--it doesn't come from the usual places.

Montier is silent about the prospects of momentum but not about small/value and quality. At today's prices, he writes, choose the latter. GMO finds both small and value stocks to be relatively expensive. It's not overly fond of quality U.S. stocks, either, but it regards them as the currently superior option.

is vice president of research for Morningstar.

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