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Rekenthaler Report

Ranking Smart Betas

Not all are equally bright.

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.)

Value--Unlike liquidity, the value factor does not present a clear economic risk. It is true that many value securities are vulnerable to downturns in the business cycle. For example, manufacturing and commodity materials companies that suffer during recessions tend to be value stocks, as are financials that get smacked by stock-market declines. However, many other value companies are not particularly economically sensitive, and value stocks do not reliably lag growth stocks during either stock bear markets or economic recessions.

To put another way, it can be just as reasonably argued that growth investing carries the risk factor of overly high prices, and of being dragged down by a bear market that punishes expensive stocks, as it can be argued that value has the risk factor of economic sensitivity.

There is a true psychological cost to owning value, though. Value securities trade at low price multiples because the issuing companies--or more broadly, entities, as the issuer could instead be a country, or government body, or any other party that seeks capital--are unpopular. Or worse. As a portfolio manager once memorably put it, a deep value stock is a stock "that makes you want to throw up in your mouth when you present it to the investment committee." The value premium has long been known and continues to persist. That suggests to me that the urge to vomit is a persistent, reliable risk factor.

Fundamental Investing--Observers differ as to whether fundamental investing, i.e. constructing an index according to a company's economic activities rather than by its stock-market valuation, is its own species of smart beta, or merely a flavor of value. I believe the latter; thus, what I write above of the value factor would apply equally to fundamental investing.

Low Volatility/Low Beta--Low volatility, low beta, and value are related factors. A stock that has a low level of volatility will probably also have a low beta, that is it will be relatively insensitive to movements in the overall stock market. It also is likely to be a value stock, as volatility rises along with a security's price multiples. For me, most of the benefit claimed for a low volatility strategy is likely to come from the related attribute of value.

Advocates of low-volatility strategies point out that few investors either retail or institutional are willing to leverage. As a result, if they wish to assume more risk in exchange for more potential return, they often find themselves considering a trade of a lower-volatility security for one that has higher volatility and, presumably, higher expected return. If they are bond investors, they may move up the yield curve by buying a longer-dated bond. As stock investors, they might swap a defensive, low-volatility stock for an aggressive, high-volatility issue. This habit of chasing higher-volatility securities, goes the argument, pushes down their expected returns and raises the prospects of the neglected low-volatility issues.

There is some logic to that argument; the structural preference for avoiding leverage creates an investment imbalance. On the other hand, there's no true risk associated with holding lower-volatility securities. The liquidity factor tangibly and truly affects the ability to trade, and the value factor causes discomfort. Holding lower-volatility securities, on the other hand, is quite pleasant. I think it possible, perhaps even probable, that the historic investment benefit from holding low-volatility securities will disappear as this smart beta grows in popularity. This smart beta is too easy to own.

Size--Of the two original smart betas that were documented in the influential Fama/French papers of the early 1990s, value and size, only the former has retained its reputation. The latter has performed in such a lackluster fashion that many former adherents now doubt if size is a risk factor at all.

As do I. There aren't any obvious additional dangers that come from holding a diversified basket of smaller-company stocks, as opposed to holding large-company stocks. I put size in the middle of the list, however, because it unquestionably is associated with liquidity--which as we have seen is very much a risk factor. I would expect a buy-and-hold investor who is careful about trading costs to do well with small-company stocks, for the liquidity beta if nothing else.

Momentum--I have always regarded the momentum factor as a mystery. I don't know why stocks that have performed particularly well in recent months should be expected to perform particularly well for the next month. I also don't know why the reverse should hold true. Various authors have attempted to explain the phenomenon--including Morningstar's James Xiong, in an unpublished paper that I will soon be reading--but never to my satisfaction.

Momentum doesn't appear to to be a risk factor. There is no adequate economic or behaviorial explanation for its persistence. Thus, I have trouble seeing how momentum can succeed now that its existence is well documented. Aside from trading costs, there is no barrier preventing investors from implementing momentum strategies.

Profitability--I share Edesess' concern about the usefulness of the profitability measure. Clearly, the stocks of highly profitable companies have indeed outperformed the stocks of other companies, as demonstrated by several research papers. The question is why. The only answer I can determine is that investors collectively were stupid. They always knew that high profitability was a good thing--how could it not be?--but they failed to price this advantage properly. They paid up for a high level of profitability, but not enough. They underpaid for the attribute.

I do not see how or why this will persist going forward. There is certainly no additional risk associated with owning highly profitable firms!

In short, the smartest betas for me are liquidity and value, with the next brightest being those that are associated with the first two attributes.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.