Getting Smart About So-Called Smart Beta

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 ETF (VTV) 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 (KO) when it underperforms than being caught holding  J.C. Penney , especially if conditions there deteriorate further.

The observed quality premium may simply result from behavioral biases. Behavioral biases will not likely self-correct overnight. As long as there is a human element in the equation, fear and greed will still sway the market. However, after a profitable strategy like quality has been discovered, and it is not merely compensating for risk, it may lose its effectiveness as more investors exploit it. But quality stocks will still likely outperform during periods of economic distress. Consequently, the strategy may still have a viable role from a diversification prospective.

Barriers to arbitrage and institutional frictions may have protected momentum in the past, but those barriers are coming down. Historically, most large money managers relied on fundamental analysis. The idea of buying stocks that went up and selling those that went down was contradictory to the conventional wisdom. Consequently, it was not a very saleable strategy. However, as momentum has gained wider acceptance in the academic community, more hedge funds have moved to exploit it. The high turnover necessary to harness momentum can create high transaction costs, making it difficult to arbitrage. But there are now more momentum funds available that help rein in transaction costs, such as iShares MSCI Momentum Factor (MTUM) and  AQR Momentum (AMOMX). While corrective arbitrage probably won’t completely eliminate momentum in the near term, the strategy may become less effective as it becomes more popular. Fortunately, a lot of investors still haven’t bought into it.

The success of the value and low volatility strategies is more likely to persist. Value stocks have a plausible risk story. These stocks often struggle during weak economic environments. Because investors demand compensation for bearing risk that cannot be diversified away, value stocks may continue to offer outperform. But even if the value effect is simply the result of behavioral biases, it is difficult to arbitrage because it can take years to payoff. For instance, investors may have penalized managers that held value stocks like  Hewlett-Packard (HPQ) over the past few years, even if those investments pan out over the long run. These stocks may also carry a stigma that can leave them undervalued, particularly because there is often little to like about them. There’s good reason for caution. Value traps, stocks that look cheap but become cheaper, can destroy wealth.

Although the low volatility effect may be easy to exploit, the institutional frictions behind it may allow it to persist. As long as active managers face leverage constraints and are compensated based on their performance relative to a benchmark they will have an incentive to overweight risky stocks to boost performance (and their paychecks). Consequently, low volatility stocks may remain overlooked and mispriced.

Combining Strategies
It may be possible to improve performance by combining some of these strategies. For example, combining value with quality may help investors avoid both value traps and overpaying for quality, if and when the market catches on.  Schwab U.S. Dividend Equity ETF (SCHD) does just that. It targets stocks that have attractive dividend yields, cash flow to debt ratios, returns on equity, and dividend growth. Putting value and momentum together is also a promising combination. Many value strategies inherently bet against momentum, which can hurt returns. In contrast, DFA’s family of value funds refrain from buying stocks with strong negative momentum, and hold onto some stocks with strong positive momentum, even as they move out of the targeted value zone. This approach helps reduce turnover, and may modestly improve performance.   

While combining strategies can help, investors should be wary of funds that try to do too many things because they often end up doing nothing. PowerShares Dynamic Market (PWC) (0.60% expense ratio) offers a great case in point. It targets stocks using quantitative metrics that fall into four broad categories: momentum, quality, management action (such as changes in capital expenditures), and value. That sounds pretty good. But since its inception in May 2003, the fund has not had significant exposure to the value or quality premiums, and has only exhibited a modest momentum tilt. Rather, it has behaved like a mid-cap blend fund. Yet, it lagged the broad market-cap weighted CRSP US Mid Cap Index by 2.4% annualized from its inception through September 2013.

Keep It Simple
Fund companies often use complexity to justify high fees, even if it generates only mediocre results. Complexity may also be indicative of data mining, which can produce a strategy that may not work out of sample. It is a good practice to discount back-test results, and demand an intuitive, common-sense explanation of the strategy you are evaluating. As a rule of thumb, if it takes longer than a minute to explain a strategy fund to a friend, it is probably not worth pursuing. Transparency and low fees are essential. Because passive investment strategies do not require human intervention, they should charge significantly less than actively managed alternatives.

 

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