Is smart beta still smart?

Decades later, questions emerge about the approach to enhancing returns using factors

Andrew Willis 27 May, 2019 | 2:00PM

Strategic beta (often called smart beta), or factor investing, entered the scene as a source of alpha that sought to distance human emotion from trading decisions. A rational approach, with a foundation built on decades of data and academia, sounds compelling. But we recently heard doubts and decided to dig into them.

Strategic beta emerged as an investment strategy to take advantage of the empirical failures of the Capital Asset Pricing Model or CAPM. According to the CAPM, a stock’s expected return should be proportional to how much it follows the ups and downs of the market (beta). The higher the systematic (non-diversifiable) risk of an asset, the larger the potential returns over the long run. Since its creation in the mid-1960s, the CAPM has been widely influential, winning one of its creators, William Sharpe, the Nobel Prize in Economic Sciences in 1990. However, starting in the late 1970s, researchers discovered factors other than beta that can predict risk and returns.

“[CAPM] fell short of explaining all stock returns – it could not explain small cap or cheap stocks – and this gave rise to the F-F 3 [Fama and French Three Factor Model]” says Prithy Serrao, Director of Business Development at SmartBe Wealth, an ETF provider that focuses exclusively on factor-based products. Add in an assessment of size and value, and you’re able to explain over 90% of portfolio returns, says Serrao.

But if investors are filling their portfolios with these factors, aren’t they accordingly also loading up on risk? Vanguard, which offers four individual factor-based ETFs in Canada, warns that these are high-risk investments, and recommends that only long-term investors who can handle this level of risk and fully understand the products, should consider adding a factor tilt to their portfolios.

Why would investors want strategic beta if adding factors also adds risks?

Paul Kaplan, director of research at Morningstar Canada, argues that certain factors need not come with additional risk. A good example of this is with value factors. A great deal of research shows that contrary to the notion that higher returns entail taking on more risk, the greater the exposure to value factors, the lower the risk of a portfolio. Furthermore, certain low-risk strategies outperform their corresponding high-risk counterparts, again showing that using a factor-based strategy does not necessarily entail taking on more risk.

The growth in strategic beta products doesn’t mean investors are running to take on more risk, says Art Johnson, Founder and CIO at SmartBe. “I believe [it] has more to do with the advantages of the ETF as a ‘carriage’ than a reshaping of the market. Managers packaged ‘alpha’, smart beta ETFs package ‘factors’.”

“Factor investing is a form of active management,” says Ben Johnson, Director of ETF Research at Morningstar. “Indeed, many successful active managers’ returns can be distilled into persistent factor tilts.”

The thing about risk, however, is that it manifests in the real world through fear. In order for investors to act on it, they need to fear an asset before they sell or avoid it – which in turn leads other investors to see it as a risk worth watching out for. Ben Johnson says that most of investors’ long-term returns will be attributable to market risk, or beta. However, anything that beta can’t explain might be a factor such as value or momentum, he says. It could also be true alpha or random noise.

How is strategic beta better than a strategy that just avoids market risk?

Investors may fear market risk, but they certainly don’t avoid it with their behaviour, says Art Johnson. “Buying stocks seems to have increased dramatically since 1980 – if equity investing was never risky, markets will efficiently reach equilibrium where the return of a stock and a bond are the same.”

“Factors are the icing on the cake,” says Ben Johnson. “The small handful of them that pass muster are underpinned by a combination of risk, structural, and behavioural forces.”

There has been much debate on whether factor premiums are due to risk or to behavioral biases on the part of investors. In Popularity: A Bridge Between Classical and Behavioral Finance, published this year by the CFA Institute Research Foundation, Roger G. Ibbotson, Thomas M. Idzorek, Paul D. Kaplan, and James X. Xiong [1]  present a framework that encompasses both explanations which they call 'popularity'. The idea is that investors are willing to pay more for securities that have popular characteristics such as a strong brand, a good reputation, a strong competitive advantage, and in doing so, willingly accept lower expected returns.

Kaplan explains: “People who buy a stock because of characteristics that are popular, for reasons that have nothing to do with risk and return, they’re the willing losers,” [2][3] adding “from a popularity perspective, factor investing works because factor exposure comes from holding unpopular securities. In other words, smart beta strategies work by holding unpopular securities.”

If factors point investors to undervalued stocks, won’t the inflows erase the potential gains?

“The notion that factor premiums are forms of risk premiums has been championed by proponents of the efficient market hypothesis, especially its greatest champion, Nobel laureate Eugene Fama. But even Fama has conceded that irrational preferences can explain the value premium,” says Kaplan, noting that premiums due to popularity effects can be permanent. [4]

Also, factors are dynamic. What is value one day might be growth the next, and vice versa. Factor screens will follow these changes.

“If you believe that all investors are flocking to cheaper value stocks – then intuitively value companies will no longer be cheap – basic economics would drive the price up,” says Serrao. “The opposite effect would take place with growth companies – they become value. This does not mean the gains from investing in value or any other factor will disappear.”

“If anything, investors should welcome inflows to a particular factor as, at least in theory, the result would be market-beating performance as new capital flocks towards potential excess returns,” says Ben Johnson, before reminding investors of the importance of patience, even when using an approach meant to separate us from the weaknesses of our human ways. “Of course, what goes up is likely to go down. Factors’ performance is cyclical, and the cycles can be long and deep.”

“When we think about factors, we are thinking about an allocation that is 10 to 15 years long – buy now and let’s chat in 15-years,” says Antonio Picca, Head of Factor-Based Strategies at Vanguard Quantitative Equity Group.

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[1] Ibbotson is professor in the practice emeritus of finance at the Yale School of Management and is chairman of Zebra Capital Management. Idzorek is chief investment officer, retirement, for Morningstar Investment Management. Kaplan is director of research for Morningstar Canada. Xiong is head of scientific investment management research for Morningstar Investment Management.

[2]
The term “willing loser” was coined by Rob Arnott in Rostad, K.A. 2013. The Man in the Arena: Vanguard Founder John C. Bogle and His Lifelong Battle to Serve Investors First. New York: John Wiley & Sons.

[3]
From Rekenthaler, John. 2019. “Putting a Price on Popularity.” Morningstar, Summer 2019.

[4]
Fama said, “Value stocks tend to be companies that have few investment opportunities and aren’t very profitable. Many people just don’t like that type of company. That, to me, has more appeal than a mispricing story, because mispricing, at least in the standard economic framework, should eventually correct itself, whereas taste can go on forever.” (Fama, E.F. & Thaler R. H. 2016. “Are Markets Efficient?” Chicago Booth Review, June 30.)  Hence, premiums due to popularity effects can be permanent.

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Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.