Good reads from around the Web.
The debate about ‘smart beta’ – the passive strategies that seek to give index investors some ‘alpha’ edge – has found its way into the Financial Times. [Search Result]
For those confused about the terms, FT journalist John Authers explains:
A stock with a beta of 1 moves exactly in line with the market at all times. The market itself has a beta of one.
Alpha is the variable that captures all market moves that cannot be explained by the market.
In financial parlance, you can buy beta very cheaply by buying an index fund. Meanwhile alpha is elusive and comes at a price.
This justifies the rise of passive index funds and exchange traded funds. They give you beta, cheaply.
But index funds are dumb, accepting prevailing valuations unthinkingly.
So why not offer index-like fund management that works automatically, and so keeps costs down, while exploiting anomalies in stock valuations to try to beat the index?
It sounds great in theory, and here on Monevator we’ve already looked at ways you might try to benefit – by investing in the value premium for example.
However we’re suspicious of claims that these strategies are a no-brainer route to extra returns for all. We suspect at the least you’ll pay in terms of higher risk, volatility, and trading fees.
I think there’s also a danger that the market will arbitrage away your smart beta strategy before it has actually delivered its excess gains into your portfolio.
Worse, you won’t know whether that’s what’s happening – or whether your strategy is just having an off-year or five – until it’s much too late.
Sick idea
Stamford University’s Bill Sharpe – who won a Nobel Prize for inventing the concept of beta – has a more visceral reaction.
Apparently the concept of smart beta makes Sharpe “definitionally sick”!
Sharpe says all such strategies are factor bets like the value one I just mentioned. He doubts they will last if widely followed.
In response, some smart beta advocates say their strategies will keep outperforming because the benefits come through rebalancing.
(A similar discussion flared up in last week’s comments on Monevator.)
Wouldn’t it be nice to live in their world?
I don’t know whether or not smart beta is a fad. I’m just a humble would-be George Soros in my spare bedroom, bereft of Nobel recognition.
But I do doubt you can get something for nothing. So if smart beta survives, I think it will come with downsides.
For his part, Bill Sharpe seems dismayed by how easily smart beta has captured the imagination:
“I used to worry: what if there’s too much indexing? But human nature means people keep on backing active managers.”
Yet who can blame them, when in theory it seems so easy to do better?
Look at this graph from Millennial Invest. It shows how a US large cap index fund would have done if you removed the bottom 10% of stocks per various smart beta style factors, such as worst value, worst momentum and so on:
A theoretical large cap ‘smart beta’ outperforms handily
Its creator, Patrick O’Shaughnessy, says that:
Diversification is good…to a point. But owning everything—even the junk—can be a drag on returns over the long term.
And he’s right, of course.
Similarly, while active investing is usually seen as a process of finding the winning stocks, we might as easily see it as a process of trying to eliminate the thousands of duds.
Factor in the risk of failure
Most active investors fail in their quest, and maybe most smart beta investors will meet the same fate.
For starters, as best I can tell the theoretical returns in the graph above ignore costs.
Then there’s human emotion to consider…
Any non-pure index strategy will sometimes do worse than the index: That’s a guarantee you can take to the bank. So anyone who bets on smart beta will have to endure periods of bad performance – not in hindsight on a graph, but in real-time over years and maybe decades, as their strategy lags the market and their time horizon dwindles.
They will have to faithfully hold on to make up for these poor years, with no certainty they’ll be rewarded. Many will capitulate at the worst time.
Is that a smart strategy?
For a small percentage of your money in the hope of just a glimpse at the Holy Grail, perhaps it’s worth a gamble.
But I wouldn’t bet the house on it.
On an unrelated note: Come on England!
From the blogs
Making good use of the things that we find…
Passive investing
- The problem with market timing – Rick Ferri
- We’re all smart – A Wealth of Common Sense
- Why do people keep buying active funds? – Pragmatic Capitalism
- Why own bonds? [US but relevant here, too] – Barbara Friedland
- Vanguard’s [US] global minimum volatility fund – Oblivious Investor
Active investing
- Reasons to bet on UK house builders – Sober Look
- Rebalance now or never – Capital Spectator
- Why bank traders can’t run hedge funds – Stock Twits
- Is the UK stock market expensive? – RIT
- A very data-driven critique of market timing strategies – Alpha Architect
Other articles
- How to lose your pack rat habit – Mr Money Mustache
- Freedom through a song, saving, and a spreadsheet – Escape Artist
- You’re not as rich as you think you are – White Coat Investor
- 1994, 2014, and the fading era of disruption – csen
- Simple ways to cut your expenses – Under the Money Tree
- Things are going to get much worse – S.L.I.S.
Product of the week: Want a new smartphone? uSwitch research cited in The Telegraph found that waiting just nine months before buying a new edition handset can reduce your costs by 24%.
Mainstream media money
Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1
Passive investing
- 5 myths and misconceptions about indexing – Vanguard
- Why the low-cost war will continue – MorningStar
- 4 Q&As about the value premium – MorningStar
Active investing
- Keynes’ way to wealth – F.A. Mag
- Why is calling a market top so hard? – Bloomberg View
- Are European stocks still cheap? – FT Alphaville
- Best hope your hedge fund manager stays married – efinancial
- Private equity does not deliver alpha – Swedroe/Seeking Alpha
Other stuff worth reading
- Beware the threat of ‘courier fraud’ – Guardian
- Housel: “I’m only just realising how stupid we are” – Fool US
- Shock! Hacks thinks strong recent returns = time to buy – Telegraph
- The classic cars that are soaring in price – ThisIsMoney
Book of the week: I’ve bought my copy of Timothy Geitner’s Stress Test
Like these links? Subscribe to get them every week!
- Reader Ken notes that: “FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.” [↩]
Smart Beta is a marketing term designed to attract attention, sales and justify expensive funds. Seems to be working pretty well so far.
The underlying principles though are factor plays on recognisable premiums such as value, momentum, profitability, small cap etc.
Some of those factors have generated excess average returns for multi-decades and across the world. Although there have been long periods when those same factors lag the market.
If more people jump on the bandwagon then the premiums go down or disappear until investors bail, the factors go out of fashion, the underlying stocks become cheap again and the premium returns.
The real test is investor’s willpower and if they’re being drawn in by marketing then we can expect that will to break as soon as the going gets tough.
Thanks for an interesting article. I am with Mr Sharpe on this one. Beware the catch phrases of the marketing people of the financial services industry. If something is as difficult to explain as smart beta, that can sometimes be a clue that smoke and mirrors are involved. Lets try to keep it simple, where possible…and few things are as simple as index investing. I agree with Monevator that tilts to value, EMs etc can make sense, but smart beta just seems like an empty phrase to me.
For the geeky types (like me) this Smart Beta marketing message is a sirens call – on to the financial rocks! It sounds so believable. But at the end of the day my whole experience of business, commerce & investing tells me “there is no extra return without extra risk”. It seems probable that the well-researched small/value tilt historically produced extra returns – however no-one seems to be able to agree whether it did so without extra risk. Going forward the increased information in this area suggests the effect will be arbitraged away. And then there is the cost of getting it. If you want more return, take more risk and increase your stock/bond ratio – at least that doesn’t cost any more.
@TI. Thanks for your weekend roundup. I enjoy clicking through them.
The “Shock! Hacks thinks strong recent returns = time to buy” Telegraph article is a very sad indictment of the shocking quality of personal finance reporting in the mainstream press.
Surely this ongoing mis-advice and thinly veiled advertorial needs to be addressed by the regulators at some point?
The gmail version of this article turned the chart into a huge string of text, maybe one to watch out for in future.
@Ash — Eek, thanks for the heads up, I see it here on one of my test accounts, too. Not sure what has happened, I thought it was a normal embed. Might be something to do with the way I scaled it, which was a bit different to usual.
The “junk” graph reminds me of the saying: “One man’s trash is another man’s treasure”.
What makes a stock have “poor momentum”, be “expensive” or have “poor earnings quality”? It is difficult to say. And it inherently relies upon an arbitrary cut-off point. In fact, are these even the right characteristics to assess? The pioneers, messrs Fama and French have even changed their opinion on which factors provide a premium.
I imagine that even slight changes to which factors you use to invest, and the cut-offs used within these factors, will greatly change your return. And you touch on this TI, with Active Manager’s records, I’m not sure their decisions will lead to the desired returns boost. Human error is real and costly.
That’s where the beauty lies in Passive Investing. There are no factors, no qualitative measures, no cut-offs or human error. You buy everything, the expensive and the cheap; the profitable and un-profitable. You don’t have to sweat over whether you should or shouldn’t buy a stock. And you can sit back and relax, knowing that time and empirical evidence is on your side.
At it’s simplest smart beta is northing more than using something else instead of mkt cap to weight a portfolio.
In what other walk of life do we allocate capital by how much they are valued at with no regard to quantity or quality?
Imagine a line of cars ranked by top speed alongside a line ranked by fuel consumption. Take the top 100 in each line and then review the parameters of price, insurance ranking, number of seats, top speed, acceleration and fuel consumption for each cohort. Which is best?
@Rob — I humbly submit that misses the point. 🙂
Theoretically, Market Cap indices represent global capital’s combined best guess at the ‘quality’ / future returns from every single company (for a given level of risk).
It is not about company size per se. It is about the weight of money behind any particular company. They are only the size they are — in terms of market cap — because of all the bets!
Theoretically with a market weighted fund, you are therefore investing along with the consensus best guess.
Anything else is basically claiming you know better than the market. 🙂
That graph of not holding the “junk” stocks reminds me of those showing how well you’d have done by not being in the market during the worst 10 days of the year.
All we need now is a financial “Maxwell’s Demon” and we’ll all be rich, rich I tell you!
Monevator,
But isn’t mkt cap measuring popularity more than best guess about future returns? The trouble is, as Rob Arnott, has pointed out, the mkt overpays for growth.
@Rob — Fine, so Rob Arnott and his followers know better than the market. 🙂
I’m not arguing it’s wrong to think that, heck I’m an active stock picker.
But let’s be clear that is what’s being said. It’s not just a different arbitrary ordering.
HYP is a subset of Smart Beta which has been used by investors for decades to generate an income. I agree with the Investor and TA, Smart Beta is jargon which will be used by the industry to extract higher fees.
TI,
The Market is always right, eventually. But we all know it can get carried away as the dot com bubble and, I would argue, now with mid caps. If you can hold the same stocks, but with a tilt to value, you should be able to get an edge on the market, providing costs are controlled.
Seen the new iShares Core ETFs?
Very low TERs: 0.07% for that on S&P 500, for example.
I think the Accumulator is spot on:
“The underlying principles though are factor plays on recognisable premiums such as value, momentum, profitability, small cap etc.”
“If more people jump on the bandwagon then the premiums go down or disappear until investors bail, the factors go out of fashion, the underlying stocks become cheap again and the premium returns.”
These factor premiums deliver outperformance precisely because there is more risk. I.e. investing in small and value stocks is riskier because you are exposing yourselves to distress risk. This is not inconsistent with market efficiency – the premium will remain because only some will be willing to take this extra risk.
I agree that most people shouldn’t bet the house on the premiums. But I disagree that we should try to time our exposure to the premiums. Though smart beta seems too popular right now, can you really predict exactly when these factors will outperform/underperform? Monevator readers already know we shouldn’t try to market time anything.
But as long as we believe that the premiums outperform the market on average, we should be comfortable allocating some money to them (depending on risk preferences of course).
Although I heartily dislike the phrase “smart beta” just as much as “fundamental indexing” there is, in my opinion, just one or two funds in this “space” (another awful phrase!) that are worth more than a look. The first is the SG Global Quality Income index, available through a Lyxor ETF and the second the rather clumsily-named VT Maven Smart Dividend UK Fund (formerly The Munro Fund).
I do think that both of these funds, which I mainly use for long-term SIPP clients, have a common-sense approach to equity investing avoiding mumbo-jumbo.
Worth a look. http://www.mavencp.com and http://www.lyxoretf.co.uk
OK so I looked at how I invest in my direct (as oppose to passive) investments in FT350 and guess what I think maybe I can call it ‘smart beta’ as I invest the same amount each time so no market cap weighting and rebalance/sell very occasionally to keep them roughly the same size etc. I had no idea that what I was doing has a name though. Yes I have main criteria – they pay or increase dividends above the FT100 average and can cover their dividends well. My Father just refers to it as the ‘buy and hold profitable companies’ strategy and he has been doing it for over 60 years… simples.