Smart Beta Investing Awaits Its Advocate
Smart beta is going through some growing pains, and Rob Arnott, co-founder of smart beta shop Research Affiliates LLC and one of smart beta’s pioneers, is a natural candidate to help lead it past these early hurdles.
The financial industry is littered with fake “innovations” that claim to be a godsend for investors, but in reality are just the latest cash cow for financial institutions. Smart beta, however, may actually be the real thing -- if it can deliver on its promise of automating the best of traditional active management and then bring that service, affordably, to investors.
That is precisely what Arnott is attempting to do at Research Affiliates, in collaboration with index provider FTSE Russell. Using the timeless principles of value investing, Arnott has developed indexes that mimic what value investors have attempted to do for generations: beat the market by buying cheap stocks. (Arnott’s smart beta indexes go by the acronym RAFI.)
Arnott's methodology is quite simple, actually. Rather than weight stocks in an index based on market capitalization -– which is how passive indexes work -– the RAFI indexes weight them based on fundamental company attributes (such as dividends, sales, book value, and cash flow). This alternate perspective allows the RAFI indexes to lighten up on the most popular, and therefore richly-valued, stocks. Presto, the RAFI indexes have a built-in value tilt.
It’s all quite promising, but smart beta is stumbling. Its most obvious problem is that, despite countless studies showing that value investing has historically beaten the market over long periods, smart beta has thus far failed to impress.
The PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio, for example, is one of several exchange traded funds that track a RAFI index. It has underperformed the MSCI EAFE Index by 1.1 percent annually from October 2007 to March 2016 (the longest period for which data is available for all investments referenced in this column; those returns include dividends).
The results in emerging markets have been similarly disappointing. The PowerShares FTSE RAFI Emerging Markets Portfolio has underperformed the MSCI Emerging Markets Index by 2.1 percent annually over the same period.
Even smart beta’s successes have a touch of grey. The PowerShares FTSE RAFI US 1000 Portfolio managed to beat the S&P 500 Index by 0.5 percent annually over the same period, but with a higher standard deviation of 2.6 percent annually. That means that investors endured a bumpier ride and ultimately got a worse risk-adjusted return than that achieved by the S&P 500 over the same period. In fact, all three funds were more volatile than their market-cap alternatives and underperformed on a risk-adjusted basis.
None of this is surprising. Value investing is well-known to be more risky than the market generally, but unfortunately value has lagged the market over the last ten years – not only in the U.S. but around the world – so investors have not been compensated for taking more risk.
The fact that the RAFI US 1000 has managed to eke out a better absolute return than the S&P 500 in this environment is no small feat. Value’s recent underperformance does not mean, of course, that smart beta will continue to disappoint (and it may actually bode well for smart beta going forward), but it remains to be seen whether investors will hang around long enough to find out.
Another headwind for smart beta is that the success of RAFI and other smart beta providers has attracted an ever-growing number of dubious smart beta strategies. I received an email recently announcing the discovery of “knowledge” as a new smart beta strategy. Yes, knowledge is always good.
Arnott has cited estimates that there are now more than 450 claimed smart beta strategies. This is worrisome, because the universe of generally accepted smart beta strategies is small: value, size, quality and momentum, among perhaps just a few others. With the sheer number of dubious smart beta strategies, many of them are likely to burn investors and tarnish the reputations of bona fide smart beta strategies (such as RAFI’s).
Smart beta has the potential to transform active management, but it’s still too unapproachable for many investors. It needs an educator-in-chief, someone with the credibility to put occasionally disappointing results in longer- term context, and to distinguish for investors between hokum and a sound approach to the markets.
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