Risky Business

Jonathan Clements

IS “SMART BETA” truly smarter and better?

The world of smart beta, sometimes called factor investing, used to be fairly easy to grasp. In 1981, academic Rolf Banz noted that small-company stocks didn’t just outperform their larger brethren. Rather, they outperformed by more than could be explained by their extra risk, as reflected in greater share price volatility. Similarly, in 1992, finance professors Eugene Fama and Kenneth French documented the strong performance of bargain-priced value stocks—and noted that this couldn’t be explained by volatility, either.

Those two insights prompted many investors to overweight both smaller-company stocks and value stocks. For everyday investors, the typical tack was to give their portfolios a tilt toward small and value stocks, by purchasing index funds that focused on these two areas. Some quantitatively driven money managers went a step further: They added a momentum overlay, favoring small stocks and value stocks that had recently outperformed, because there was also evidence that short-term winners continued to shine.

“This isn’t just some interesting academic exercise. Rather, it’s big business. Wall Street has been quick to exploit these insights.”

In the years since, researchers have documented a slew of additional factors. For instance, historically, you could have notched surprisingly good results by favoring securities characterized by lower price volatility, higher yields and higher quality (as reflected in, say, higher gross profitability or lower debt).

Researchers have found that favoring these factors can goose performance in the U.S. and foreign markets—and can help in picking stocks, bonds and currencies. But this isn’t just some interesting academic exercise. Rather, it’s big business. Wall Street has been quick to exploit these insights, most notably through a tidal wave of new exchange-traded index funds.

Has all this been overdone? Critics have noted that the funds often don’t fare as well as the research suggests. A recent Bloomberg Businessweek article questioned whether some of the factors identified reflected not disinterested research, but data mining. Even Vanguard Group founder Jack Bogle has chimed in against smart beta funds.

Are the critics right? For those of us without finance PhDs, this debate can be tough to sort out.

Back in the 1990s, I was more skeptical about factor investing, but I’ve slowly warmed to the idea. With factor investing, you’re taking human judgment out of the mix—and with it the potential taint of emotion—and replacing it with systematic investing based on historical evidence and academic theory. That seems like a far more promising approach than old school methods, such as trying to uncover market-beating stocks by reading SEC filings, interviewing company management and making financial projections.

Four Doubts. Today, in my portfolio, I own index funds that overweight value stocks and smaller-company stocks, both in the U.S. and abroad. I’m not 100% convinced this will boost my portfolio’s return. But I figure that, if I suffer a patch of underperformance, I’ll have the patience to sit tight, and the long-term damage, if any, will be modest. Why do I have doubts? There are four reasons.

First, by owning a portfolio that looks different from the broad market, I’m making a market bet—and I could be wrong. Don’t want to take that risk? My advice: Purchase a total U.S. stock market index fund, a total international stock index fund and a total bond market fund. With that combo, you’re guaranteed to outperform most other investors with a similar asset allocation, because their results will be dragged down by their higher investment costs.

That brings me to my second reason: These broad-based index funds are cheaper than factor-tilted index funds. That means that factor funds need to deliver not just superior performance, but performance that’s sufficiently superior to overcome their cost disadvantage. That cost disadvantage has lately looked slightly more daunting, as major index-fund providers engage in a price-cutting war to promote their flagship funds that track broad market indexes. In essence, many index-fund providers are using these broad-based index funds as loss leaders to attract new customers, who they hope will then buy more expensive factor-tilted index funds.

Third, we should never forget that we have only one history of capitalism. That history may be a rotten guide to the future. Perhaps the factors that have been identified are an historical quirk, not an enduring advantage.

“If there’s no added risk, it’s an easy choice for investors: They’ll realize there’s a free investment lunch to be had and flock to buy the stocks involved.”

Finally, markets are made up of humans—and humans learn. If a chance to beat the market is uncovered, folks rush to take advantage and the opportunity can quickly disappear. For instance, since Rolf Banz’s paper on the small-stock effect appeared in 1981, small stocks have outperformed blue chips, but the margin of victory has been modest. Could it be that the large historical outperformance by small stocks reflected not massively greater risk, but rather a mispricing—and that mispricing has now been rectified, as investors have learned about the small-cap effect and moved to take advantage?

That, in a nutshell, is the dilemma that all factors face. For a factor—whether it’s the small-cap effect, value, momentum or something else—to continue to deliver superior returns, it must involve added risk, for which investors are then rewarded. If that isn’t the case and there’s no added risk, it’s an easy choice for investors: They’ll realize there’s a free investment lunch to be had, they’ll flock to buy the stocks involved, the share prices will be bid up and future performance will be no better than the rest of the market.

So do these factors involve added risk? Again, go back to the small-cap effect. When modern portfolio theory was first formulated, it was assumed that risk was captured by volatility—and the surprise with small stocks was that their outperformance was larger than could be explained by volatility alone. The assumption: Something else must be going on, but nobody was quite sure what it was.

We have the same problem with the other factors that appear to deliver outperformance. Their outperformance can’t be explained by their greater volatility, so either there’s some risk involved that we don’t really understand—or there isn’t any greater risk involved, in which case the performance advantage probably won’t persist.

Embracing Risk. So where does that leave us? If something is obviously riskier, there should be a return advantage. That’s the case with stocks relative to bonds. Those who have a larger allocation to stocks can reasonably expect somewhat higher returns over the long haul. Similarly, within stocks, it’s pretty clear that smaller companies and emerging markets are dicier propositions than blue chip companies, so it seems reasonable to expect some extra return—even if the extra return from small stocks isn’t as great as history suggests.

But what about everything else? I’m not convinced there’s greater risk involved with, say, value stocks or stocks with short-term momentum. Instead, if there’s any reason these factors work, it strikes me that it’s probably behavioral.

Investors get too excited about growth companies, and pay too much for their stocks, and they’re too pessimistic about the prospects for value stocks, so there are bargains to be had. Similarly, momentum may reflect an excess of caution among investors, who are slow to change their minds when faced with a corporate turnaround, so it takes a while for good news to get fully reflected in a company’s share price. That doesn’t mean that value and momentum strategies won’t outperform over the long haul, but investors could overcome their behavioral biases—and the performance advantage may disappear.

Because of that risk, I wouldn’t bet the ranch on any factor. Instead, you might anchor your portfolio with a total U.S. stock market index fund, a total international stock index fund and a total bond market index fund. Want to be a tad more clever? Go ahead and add a few factor-tilted index funds—but realize you’re taking a risk that may not get rewarded.

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