The search for returns is the driving force for innovation in the investment industry, even more so at a time of low interest rates and low macroeconomic growth. As soon as someone discovers a new way of making a healthy return, others quickly adopt their strategy. But there is always the risk that some people take it too far. That seems to be the trajectory over the past decade with the investment strategy known as factor-based, smart beta investing, at least according to some key industry figures.
The name for the strategy comes from its use of a tweaked version of passive (or beta) investing coupled with a focus on particular qualities of different stocks, known as their fundamentals or factors. In practice this means that, rather than building an investment fund based on the market capitalisation of individual stocks, as traditional index-tracking funds do, smart beta investments are made on the basis of other stock characteristics. The most commonly identified factors include value, volatility, momentum and size, but hundreds of others have been identified. An important element is that, once a factor has been identified, the investment fund will follow a defined set of rules, which keeps it some way short of being an actively managed strategy.
Arguably, investors have always done this to some extent, but the strategy in its modern form dates back just over a decade. In 2005, an article called ‘Fundamental indexation’ appeared in the Financial Analysts Journal
, co-written by Rob Arnott and Jason Hsu, co-founders of California-based investment firm Research Affiliates, and their colleague Philip Moore. The authors argued that picking stocks based on the fundamentals of company performance (such as revenue, cash flow or dividends) brought in higher returns than the normal, market capitalisation-based approach.
The idea struck a chord with investors and money has poured in. According to London-based research firm ETFGI, by the end of June 2016 some $429bn was invested in smart beta funds around the world. The US dominates the market, with $390.2bn of assets, followed by Europe with $26.7bn, Canada with $9.4bn and Japan with $832m. Much more is expected to flow into the sector in the future. US investment giant BlackRock has predicted the figure will grow to $1tn by 2020 and $2.4tn by 2025.Smart beta strategies
According to Vanguard Research, there are more than 300 factors that are being used to inform smart beta investment strategies, and around 40 more are identified every year. However, those numbers don’t necessarily tell the full story and there could well be plenty of duplication.
“Sometimes what happens is there are many different metrics measuring the same underlying factor,” says Ana Harris of State Street Global Advisors. “For example, if you think about value you can look at valuations at price to book or price to earnings or price to cash flow. That's three different metrics to measure the same factor.”
Other research has found that no single factor consistently outperforms the market over time. A report for Vanguard Research published in April 2015 looked at seven factors from 2005 to 2014. Over the ten years, all the factors had periods of relatively strong and weak performance.
While some money has been placed into single-factor exchange-traded funds (ETFs), the market has become increasingly complex and some funds now track several different factors at the same time. As returns vary between factors and are often not closely correlated (see right), it means investors benefit from diversification if a number of them are put together in a single portfolio.
“Multi-factor investing is where the conversation is at the moment,” says Ana Harris, head of equity portfolio strategies for the EMEA region at State Street Global Advisors. “Having one portfolio that combines multiple factors makes sense for a lot of people. That said, some investors want to weigh the factors themselves, so even if multi-factor is an area of growth, the demand for single-factor will still remain robust.”
The cost for investors varies depending on the fund but, as befits a strategy which sits somewhere between passive and active investing, the costs are usually significantly lower than actively managed funds while being higher than simple index-tracking funds. Advocates argue that the higher returns from factor-based funds more than offset the higher costs compared to passive funds.
According to Morningstar, the average fee charged by smart beta ETFs in Europe is 0.39%. By contrast, the total expense ratio (TER) for actively managed funds is typically 1% to 2%, while passive, market cap-weighted ETFs charge between 0.05% and 0.2%. Smart beta costs have been falling though, dropping from a level of 0.43% five years ago, and Morningstar says that, as the market continues to mature, smart beta fees are likely to fall further still.
All this paints a rather rosy picture, suggesting a market that is growing at a steady clip and giving investors the returns they want. However, the industry has been turned on its head this year by a series of critical commentaries. Once again it has been Arnott who has been at the centre of things. In a paper
published in February, he said factor returns were in reality much lower than recent performance suggested and a lot of investors were “performance chasers” who were pushing prices higher and thereby reducing potential future performance. The paper, entitled How can smart beta go horribly wrong?
said there was a “reasonable probability of a smart beta crash”.
Since then a series of other reports from Research Affiliates have expanded on these risks. The principal charge being made against smart beta funds is not that the strategy is always wrong, but that some versions of it are. Some funds appear to be doing well, not because the factor is performing well, but because the stocks included in the fund have become more expensive. That in turn suggests that those funds are due for a fall once valuations return to a fairer value.
Criticism of smart beta investment is far from new, but coming from Arnott it carries particular weight. Luba Nikulina, Global Head of Manager Research at Willis Towers Watson, has been among those raising doubts for some time about the growing complexity of the market. In February
, she said, “We are genuinely concerned about the proliferation of products claiming to be smart beta, particularly in the equity area. Not all smart beta is created equal: it should be easy to describe and understand but many labelled products are not, are often poorly implemented and seem naïve about the inherent risks. Investors should beat a smart retreat from these.”
Some industry veterans are even more critical. For example, Jack Bogle, founder of Vanguard Group and the instigator of index-linked funds in the 1970s, has consistently cast doubt over the idea of smart beta.
A good outlook?
But others are more optimistic. Using a baseball metaphor, Rob Nestor, Head of iShares Smart Beta Strategy at BlackRock, suggests the industry is only getting going. “We think we're probably at the bottom of the first innings, maybe the top of the second innings in terms of factor adoption,” he says. “We think the primary growth areas are going to come from risk mitigation strategies and multi-factor approaches. But education is paramount. Factor investing isn't really that new but it is new to most investors.”
Where this leaves investors is pretty much where they always have been: there is no certainty about the future, investing always carries with it a degree of risk, and some funds will do better than others over time, whether because of luck, judgment or both. If nothing else, the debate over smart beta investing at least highlights the fact that even the best investment ideas are only as good as their execution. The popularity of smart beta investing is unlikely to disappear anytime soon, but a dose of realism is no bad thing.