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Fear and Greed Feed 'Strategic Beta' Returns

Strategic beta indexes break the traditional indexes' price link to capture a contrarian rebalancing return, says Research Affiliates chief investment officer Chris Brightman.

Fear and Greed Feed 'Strategic Beta' Returns

Ben Johnson: Hi, I'm Ben Johnson, director of manager research covering passive strategies with Morningstar.

Today I'm at the 26th Annual Morningstar Investment Conference, and one of the many topics that we've been discussing today is strategic beta or "smart beta." To that regard, I'm very pleased to be joined by Chris Brightman. Chris is the chief investment officer of Research Affiliates, and I can think of few better people to discuss this topic with me.

Thank you for being here, Chris.

Chris Brightman: Sure, pleased to be here.

Johnson: The first question, the question I think is on the minds of many, is what is strategic or smart beta?

Brightman: Smart beta or strategic beta refers to a growing category of investment strategies that are typically delivered through indexes. The reason that the smart beta strategy, or the alternative beta strategy, or what we like to say the fundamental index, is becoming so popular is that it has delivered on the promise that we made 10 years ago, when we first described the opportunity to create a rebalancing return inside of an asset class. If you systematically sell the companies that have outperformed and buy the companies that have underperformed and rebalance the portfolio, you can have a rebalancing return inside of an asset class.

Now, in order to have a rebalancing return, you have to answer the question, rebalanced to what? There has to be an anchor for the purpose of rebalancing, and that's what these alternative or strategic or smart beta indices do. They use a non-price-weighted anchor so that they can capture a rebalancing return inside of an asset class.

Johnson: So really, in your definition, it's smart to break the link with price as most market-capitalization-weighted indexes are strictly formed on that basis.

Brightman: Yes. I don't think a good reason to have more of a stock in your portfolio is that the stock price went up. Or a good reason to hold a much smaller weight in a company is that its stock price went down. In fact, I would rather start to own a little more of the companies as their prices decline and a little less of the companies as they become more and more pricey.

Johnson: When you unpack the sources of return that are driving these strategies, what are they? Are they risk premia? Are they exploiting behavioral biases that investors demonstrate? How do we think about these?

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Brightman: I think it is deeply behavioral. The market, Mr. Market, gets very excited about the prospects for some companies, whether those are biotech stocks or Internet stocks or sometimes it could just be safe companies like utilities, and investors are comfortable paying a premium price for those sorts of securities.

On the other hand, there are other companies that people are fearful of--financial institutions in late 2008 and 2009, or say, Russian resource stocks today, and their prices are very depressed. And the market pays you a premium, you get higher returns on average, by investing in stocks that people are fearful of and that are trading at low prices.

Maybe it would be useful to stop arguing about whether markets are perfectly efficient or not efficient, or whether it's a risk premium or return premium, and think of it as being paid for making the uncomfortable decision to own without a favor. That's the visceral, easy-to-understand source of this return opportunity.

Johnson: If we look back at now a decade, in some cases, of live track record for some of the Research Affiliates indexes, it's clearly paid to exploit some of these phenomenon, but if there's one thing we all as investors should know, it's that past performance is not indicative of future results. So what gives you confidence that these risk premia or behavioral biases that you've been paid to take over the course the past 10 years will persist into the future?

Brightman: Well, one thing that gives us comfort is that, as you said, over the 10 years and growing since we launched this concept, the live performance has been completely in line with the simulated results that we looked at going decades and decades and decades into the past, and not just in the U.S. market, but in the U.S. market and the Japanese market and the European market and in emerging markets.

So everywhere we looked historically, you see this pattern of momentum in the short run, mean reversion in the long run, and the opportunity for rebalancing return. Since we did the studies, all of our products have produced returns in line with what we simulated. What we published in the paper was about a 2% excess return relative to a cap-weighted index, and that's about what has been delivered.

As for why I think it will continue to be the case, it's just down to greed and fear. These strategies simply automatically implement what traditional value investors have been telling us for decades and decades and decades. Sell when others are greedy and buy when others are fearful. It's that discomfort or fear premium that you are earning in your portfolio.

Johnson: So, really at the core of all of these complexities is the basic fight or flight response that we all naturally experience.

Brightman: I think that's exactly right. If you imagine a herd of gazelle on the African Safari, they are all herded together and eating the grass that's trampled and yucky. And the wonderful green grass that's away from the herd, the gazelle don't want to eat that grass, because it's risky. If you get too far away from the herd, a lion may come and eat you, and so we have this herding behavior and this desire for comfort that creates this opportunity. And as long as humans are involved in markets, I think we'll continue to see this opportunity.

Johnson: Chris, I appreciate you being here, and helping shed some light on this topic. Thanks again for joining me.

Brightman: You're welcome.

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