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Quit Calling It Smart Beta

Click to enlarge Image source: istockphoto.com. Used with permission. Quit Calling It Smart Beta Last week, an advisor forwarded me this Financial Times article, ” Smart Beta Not Quite as Clever as Marketed ,” asking for my comment, to which I immediately responded, “the only aspect of the article I agree with is the title.” Since arriving at 3D Asset Management, I’ve published two articles on ETF investing: ” ETF Product Development: Innovation Versus Over-Engineering ” and ” Why ETFs (and Why Strategic Beta ETFs) .” In both these articles, I have advocated for our use of factor-based ETFs, commonly known as alternative beta or strategic beta. Despite what appears to be an industry-wide adoption of the term, I refuse to use the label ‘smart’ beta for factor-based ETFs. Here is what I wrote in “ETF Product Development:” …’smart’ beta (factor) investing is not ‘smart’ at all but just a reformulation of the Dimensional Fund Advisors’ (DFA) strategy of investing in areas of the market which have afforded higher risk premia over the long run. ‘Small cap’ and ‘value’ factors outperform over the market because they come with higher risks which investors are compensated for over the long run – these factors are no ‘smarter’ than a traditional market-cap based approach such as the S&P 500. ‘Smart beta’ is a marketing label used by ETF sponsors to get advisors more comfortable with alternative methods of indexing. But it is no more nefarious than that, unlike what is implied by the Financial Times article critiquing factor ETFs. The rollout of strategic or alternative beta ETFs reflects innovation on the part of ETF and index providers to give retail investors access to market segments and themes historically only available to professional/institutional investors. What follows is a section-by-section critique of the FT article: Has the investment industry’s marketing push outsmarted itself? For several years, huge effort has gone in to selling “smart beta” funds. It has worked, creating great excitement. Now, not at all surprisingly, the backlash has begun. 3D’s Response: “Backlash” from whom? From those most threatened by the advent of factor-based ETFs? Strategic beta ETFs capture much of the systematic elements of many actively-managed strategies in cost-effective and tax-efficient vehicles. So who feels most threatened by this wave of product innovation? That is, of course, rhetorical. Smart beta comes up with a strategy to beat the index, which can itself be made into an index with simple rules. The advantage of doing this is that funds that track an index can be run far more cheaply than active funds, which face a far higher bill for research and managers’ salaries. So if a winning strategy can be reduced to an index, it should be possible to cut costs, and offer a superior return to investors . 3D’s Response: Agree with most of this statement, except this notion of “winning.” The goal of investing isn’t to ‘win’ but to achieve long-term financial goals, whether with indexing or with active management. If the focus is just on ‘winning’, then one misses the entire point of investing in the first place. For instance, a dividend-focused strategy is designed not so much to outperform the broad market-based benchmark (i.e. the S&P 500) but to provide investors with desired portfolio characteristics, namely 1) total returns sourced more from dividend income than capital appreciation and 2) lower equity market sensitivity. Does this strategy ‘lose’ if it delivers on this objective even though it may underperform the market-based benchmark? Smart beta strategies are now proliferating but most commonly stem from anomalies identified in the academic literature. Perhaps most importantly, there are Value (cheap stocks do better than expensive), Momentum (winners keep winning, and losers keep losing), and Low volatility (relatively stable stocks perform better). All will have periods when they do badly. All perform well in the long run. Other popular strategies involve weighting portfolios by companies’ sales, or revenues, or dividends . From these building blocks, investment managers have now built multifactor funds in different proportions, and come up with a dizzying array of new factors. And they have sold a lot of funds on the back of it. 3D’s Response: As a former quantitative portfolio manager, I can reasonably say that most of the historically effective factors are now captured in some form by ETF products. I don’t know what the true library of significant and investable factors consist of, but I am confident it is between the three originally proposed by Fama/French (market, size, value) and somewhere in the range of 15-20. But is it a “dizzying” array? First, one must distinguish between an ETF that captures an historical risk premium or anomaly such as value or momentum versus an ETF built on rules designed to capture a specific investment theme such as Goldman Sachs Hedge Fund VIP ETF which would screen for top hedge fund holdings of individual stocks. Second, the ‘dizzying’ array of factors is partly driven by legitimate differences on what is the best rule-based design to capture a factor. Strategic betas such as value and quality can be defined differently, but many of them achieve similar results. ETF strategists such as ourselves conduct due diligence to get underneath the hood on what the factor is trying to achieve and then provide research opinions on whether a particular ETF provides the best rules-based design given the cost. But there is a problem. In theory, and in practice, once a market anomaly has been observed, it cannot continue. There are two reasons why future performance may be worse than the historical backtest suggests, outlined by Pete Hecht, chief market strategist for Evanston Capital Management, in a recent paper. First, the back-test may have been “data-mined.” In other words, the researchers fiddled to find a formula that delivered the very best result for the period they were looking at. This may be due to dishonesty, or may happen unconsciously. 3D’s Response: First, a straw man warning. Pete Hecht from Evanston may be correct in his observation of Fama/French, but some disclosure should have been made that Evanston has a vested interest in dismissing smart beta as a flash in the pan fad since Evanston serves as a multi-manager hedge fund-of-fund, whose value proposition (along with much of traditional active management) is under competitive threat from strategic beta investing. That said, Hecht’s first argument is facetious at best and indicts any data-driven approach to investing. There are clear standards for what constitutes robust backtesting, namely is the observed factor anomaly consistent, robust, and reliable across time and across different markets? There is ‘true’ data mining which is to throw as much stuff on the wall and see what sticks and there is robust backtesting where there is a clear and intuitive rationale for the observed behavior. A second problem is arbitrage, and the very existence of smart beta funds feeds this problem. Once you know that cheap stocks outperform, the logical response is to buy cheap stocks. If many do this, cheap stocks’ price will rise until they no longer outperform. 3D’s Response: This ignores the fact that underlying factor behavior is a risk-premium or behavioral explanation. ‘Arbitrage’ implies there exists some systematic mispricing between two or multiple assets and that a well-functioning market should reduce this mispricing such that it cannot be exploited over a sustained period of time. However, those who hold to a risk premia view of factor investing believe such premia exist precisely due to rational pricing on the part of investors. Take the value risk premium as an example. As Fama/French originally argued in their 1992 paper, ” The Cross-Section of Expected Stock Returns ,” the value effect (as proxied by book value/market value ratio) is “the market’s assessment of its value [which] should be a direct indicator of the relative prospects…” In other words, ‘cheap’ stocks are cheap for a reason, because they are riskier than the overall market. Cheap stocks tend to be financial companies that trade close to book value due to regulatory or financial leverage reasons or companies with highly cyclical (and uncertain) earnings that the market is not willing to assign a premium multiple to. I won’t delve into the rationales driving the other main factor categories, but the historical size and value risk premia as documented by Fama/French are rooted in highly intuitive economic rationales and not the result of some creative backtests with no fundamental rooting as implied by the FT article. Mr. Hecht took Mr. Fama’s formulas for determining which stocks were cheap, and saw how the strategy would have performed starting in 1992 and carrying on to the present. In all cases, whether measured by straight performance or adjusted for risk, they did much worse after the paper’s publication than they had before it. The reduction in performance ranged from 30 to 71 percent. The value effect had diminished. 3D’s Response: There is some evidence that the long-term risk premium has shrunk as market participation has expanded and has become more electronic and global. However, Mr. Hecht’s observation wouldn’t just apply to the value premium but to the entire market risk premium itself. If equity market investing has become less ‘risky’ then investors should expect to be compensated with less return over time. But common sense intuition would hold that equities are riskier than bonds over the long run and that risk can fluctuate during different economic and inflationary cycles. Otherwise the entire notion of rational capital pricing would collapse into absurdity. No one would suggest that the equity risk premium should go to zero (except these guys ) just because the markets have gotten more efficient. Likewise, few would argue that small cap stocks should not trade at a premium versus large cap stocks (i.e. would you be willing to accept the same premium for holding Pfizer (NYSE: PFE ) than you would a small, speculative biotech?). And the same holds for value stocks as mentioned above. However, Hecht’s second argument brings up broader implications for active management. If there is a diminishing return to value and small cap investing (and it’s debatable since size and value have shown long-term persistency across multiple markets), then this would have profound implications for all of active management, not just strategic beta. Hecht’s arguments of diminishing returns to factor investing has even worse implications for traditional active management and hedge funds where much of the alpha they provide can be sourced from such systematic factors. As more active managers and hedge funds become ‘discovered’ and ‘popular’, then presumably their edge in delivering alpha should also be reduced. That leads to another problem, identified by Rob Arnott in a paper for Research Affiliates, a pioneer of smart beta. A strong backtest at any point in time, he reasons, may be because the factor tested has become expensive. Very perversely therefore, a strong backtest almost becomes a reason not to buy into a strategy. And if a strategy looks good now simply because it is expensive, that may be an active reason to fear that it will now perform badly. Conversely, it might imply that factors that have done poorly of late – and as the chart shows, value has badly lagged behind the market ever since the financial crisis – are now cheap and worth buying, for those with the intestinal fortitude to do so. Meanwhile it is worth checking whether low-volatility and high-momentum stocks, both still performing well, look over-expensive and due to revert to the mean. 3D’s Response: Are there more opportunistic times to buy factor portfolios like value? Sure, that’s almost axiomatic. Buying value seemed to be the only strategy that worked in 2009 following the steep sell-off during the global financial crisis, but when it looked like large banks like Citigroup (NYSE: C ) and Bank of America (NYSE: BAC ) would go under, it would have required heroic “intestinal fortitude” to bet on value at the height of uncertainty. When a long-term strategy looks especially cheap versus its history, then it will likely have a higher payoff if you believe in the long-term rationale for owning that strategy in the first place. I find it interesting that Research Affiliates is now just commenting on this after an especially tough period for the RAFI indices, notably in emerging markets. Despite de-emphasizing the role of ‘price’ in its construction, RAFI has historically correlated with value-style indices. One rarely hears from value managers to avoid their strategies because the underlying valuation spreads are narrow (and less opportunistic to buy into the strategy). During these moments when valuation spreads were narrow, chances are the prospective investor had been regaled with Morningstar ratings on past performance, sort of like the backtests Research Affiliates is critiquing. I do believe factor (and strategy) timing is difficult, particularly if one uses valuation spreads as part of the allocation process. Please see this article published by Larry Swedroe on ETF.com where he summarizes research questioning the use of valuation as a timing tool for factor selection. However, I would not rule out valuation as a reason to avoid a factor or to opportunistically invest in it; it is a matter of perspective and what other aspects are incorporated into the decision-making. The bottom line is that investment processes incorporating strategic beta ETFs should not bet on one or two factors but should be diversified across a variety of factors so as to minimize the disruption due to valuation conditions. A final issue: risk. Piling into one particular factor is inherently more risky. For Andrew Lo of Massachusetts Institute of Technology, one of the world’s most respected financial theorists, the problem with “smart beta” is that it can easily morph into “dumb sigma” – the Greek letter used for volatility. 3D’s Response: This is awkwardly written. Yes, investing in just one factor is riskier than being diversified across multiple factors. Yet, how does this morph into “dumb sigma?” Many things can lead to “dumb sigma.” Buying equity on margin can be considered “dumb sigma.” “Dumb sigma” just reflects poor portfolio construction and risk control and is not necessarily indicative of strategic beta investing. The main takeaway is that alternative / strategic beta ETFs have given retail investors more options than what has been historically available. These are not a panacea for beating the markets but can serve as cost-effective to gain targeted exposures not directly accessible via traditional market indices. The goal is not to “win” but to build more robust portfolios to achieve long-term investment goals and objectives. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Monetary Madness: How Inflation Risk Changes The Game

Spring is a great time of year for sports fans. Spring training is transitioning to a new season of hope for baseball fans, hockey teams are making their final push to the playoffs, and college hoops fans get to immerse themselves in brackets and March Madness. A big part of what makes sports competition so interesting and exciting is something that is not exciting at all: They are all played under the conditions of common rules and standards. Time periods, playing areas and even equipment specifications are controlled. Arguments can ensue over such tiny discrepancies as a second or two on the clock or a couple of pounds of pressure in a football. While sports fans rightfully push back against discrepancies so as to ensure the integrity of the game, investors are far more quiescent when inflation alters the value of money. In exploring the issue of inflation, it helps to keep a couple of points in mind. One is that the dollar (or any form of money) is a standard of value just like a minute is a standard of time and a pound is a standard of weight. Since money is used to measure the value of our work, our skills, our belongings and many other things, changes to its value have implications that run deeply through the economy and through society. Another point is that despite the overarching importance of money as a standard of value, monetary officials have coalesced their policy making around an inflation target of two per cent per year. In doing so, they have succeeded in persuading people that two percent is a very small number and have inured much of the investing public to the risks inflationary policy. While two per cent per year may seem like an almost trivially small number, it becomes very meaningful when compounded over many years. This can be illustrated by a basketball example. Let’s imagine for a minute, that the powers that powers-that-be in the NCAA set a two per cent per year inflation policy on the distance of the free throw line from the basket. In the first couple of years, the line would only move about three-and-a-half inches per year and might not be so bad. But after just seventeen years, the free throw line would move out beyond the college three point line. The implications would be widespread and would fundamentally change the nature of the game. Indeed, many investors are sensing that the investment “game” may be changing. Based on an increasingly tenuous relationship between underlying economic fundamentals and stock prices and increased volatility in the markets over the last year, it is an absolutely appropriate concern. Jim Grant neatly summarized the situation as he sees it in the February 26, 2016 edition of Grant’s Interest Rate Observer: “In times past, the standard of value was fixed while economic activity was left to fluctuate. Now, it’s the trend growth in economic activity that – supposedly – is stable; monetary value is what gives way.” Insofar as this is correct, it suggests that the investment landscape has changed in a meaningful way. Since the value of analysis pertains most to variables that fluctuate, Grant’s view suggests that analytical efforts increasingly ought to be applied to monitoring and assessing the value of currency rather than to determining levels of economic activity. One way in which “monetary value giving way” makes investing more difficult is because it is poorly understood by many economic and monetary officials. John Hussman hits on this point in his weekly letter [ here ], “It’s endlessly fascinating to hear central bankers talk about the effect of monetary policy on inflation and the economy, because they confidently speak as if the models in their heads are true – even reliable. Yet virtually nothing they say can actually be demonstrated in historical data, and the estimated effects often go entirely in the opposite direction. This is particularly true when it comes to inflation and unemployment – precisely the variables that are the targets of central bank policy.” John Cochrane from the University of Chicago also recognizes this knowledge gap in his article “Inflation and Debt” [ here ], “Many economists and commentators do not think it makes sense to worry about inflation right now. After all, inflation declined during the financial crisis and subsequent recession, and remains low by post-war standards.” He follows that, “But the Fed’s view that inflation happens only during booms is too narrow, based on just one interpretation of America’s exceptional post-war experience. It overlooks, for instance, the stagflation of the 1970s, when inflation broke out despite ‘resource slack’ and the apparent ‘stability’ of expectations.” These comments converge on the same point: The two prominent schools of thought in regards to inflation, keynesianism and monetarism, both suffer from serious shortcomings. Cochrane notes that, “One serious problem with this view [keynesianism] is that the correlation between unemployment (or other measures of economic ‘slack’) and inflation is actually very weak.” In regards to monetarism, Hussman reveals, “Economic models of inflation turn out to be nearly useless for any practical purpose… it’s very difficult to explain most episodes of inflation using monetary variables.” Unfortunately, these flawed theories serve as the bread and butter of mainstream economists, including those at the Fed. In short, many of the leading voices on inflation are misleading. The key incremental insight that both Hussman and Cochrane gravitate to is that the value of paper money, fiat currency, depends fundamentally on confidence in the system that supports it. As Hussman describes, “The long-term value of paper money relies on the confidence that someone else in the future will accept it in exchange for value, and ultimately, that’s a matter of varying confidence in the ability of the government to meet its long-term obligations… confidence in long-run fiscal discipline is essential.” Cochrane explains, “Most analysts today – even those who do worry about inflation – ignore the direct link between debt, looming deficits, and inflation.” Part of the reason is historical context. He follows, “While the assumption of fiscal solvency may have made sense in America during most of the post-war era, the size of the government’s debt and unsustainable future deficits now puts us in an unfamiliar danger zone – one beyond the realm of conventional American macroeconomic ideas.” This is a key point. As Cochrane acknowledges, the “assumption of fiscal solvency may have made sense in America during most of the post-war era”. But things have changed. Investors need to transition beyond “the realm of conventional American macroeconomic ideas” and seriously re-evaluate the country’s fiscal solvency risk – and, therefore, the potential inflation risk. The persistence of large structural fiscal deficits caused by unsustainable and ever-increasing entitlement obligations, in the context of a divisive political landscape, offers little hope that fiscal challenges will be addressed in time to preserve the value of the dollar. Finally, while inflation appears to be an accident waiting to happen, its timing is impossible to predict. Cochrane elaborates: “As a result of the federal government’s enormous debt and deficits, substantial inflation could break out in America in the next few years. If people become convinced that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of dollars today – driving up the prices of goods, services, and eventually wages across the entire economy. This would amount to a “run” on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable.” Investors can take four key points away from this analysis. One is that even low but persistent inflation can have a meaningful effect over a long investment horizon. Just like in the basketball example, the effects seem small at first, but become quite significant over time. While two per cent per year inflation may initially seem like a small number, over an investment horizon of fifty years, such inflation will erode the value of a dollar to 37 cents. Historically, it hasn’t felt that bad because strong asset returns have more than offset the effects of inflation. However, if you don’t own assets that re-price to offset inflation, or if such strong asset returns fail to be realized in the future, inflation will be a far more painful experience. A second point is that the “fiscal solvency” element of inflation risk eludes most conventional economic thinking – and conventional economic thinking constitutes much of what informs investment advice, asset allocation decisions and public policy. The effect is that many of the guardians of investments (financial advisers, wealth managers, consultants, et al.) understate inflation risk, and sometimes significantly so. Regardless of how understated inflation risk becomes manifested in a portfolio, the outcome is the same: it leaves investors vulnerable to not having adequate purchasing power to meet their spending plans in retirement. Third, the emergence of inflation risks creates a new challenge for investment analysts and managers. Now, in addition to evaluating fundamentals, analysts must add a whole new skill set by learning to perform credit analysis on the US government. This involves determining the probability and degree of fiscal insolvency and to some extent, handicapping the tipping point as to when confidence in the dollar might run out. This additional exercise not only complicates the analysis, but also adds a great deal of uncertainty. Finally, the fourth point is that inflation risk, when viewed as fiscal solvency risk, is difficult to manage. As Cochrane highlights, investors do not get the luxury of early warning signs: “Like all runs [on the dollar], this one would be unpredictable. After all, if people could predict that a run would happen tomorrow, then they would run today. Investors do not run when they see very bad news, but when they get the sense that everyone else is about to run. That’s why there is often so little news sparking a crisis, why policymakers are likely to blame “speculators” or “contagion,” why academic commentators blame “irrational” markets and “animal spirits,” and why the Fed is likely to bemoan a mysterious “loss of anchoring” of “inflation expectations.” And for those still harboring notions that inflation can be controlled by a central bank, Cochrane adds, “Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem – the challenge of out-of-control deficits and ballooning debt. Today’s debate about inflation largely misses that problem, and therefore, fails to contend with the greatest inflation danger we face.” In short, managing inflation risk is an uncertain and probabilistic exercise akin to forecasting the weather: You can’t specifically forecast storms; the best you can do is to recognize that prevailing conditions may produce storm activity and to manage affairs accordingly. All of these points suggest that the “game” of investing has fundamentally changed. The emergence of large fiscal deficits exacerbated by exploding entitlement obligations is creating challenges to fiscal solvency that this country has never seen before. Political divisiveness offers little hope of resolution. As a result, the preconditions are ripe for unpredictable outbreaks of inflation. The implication for investors is to be aware of these relatively new challenges and to re-evaluate their strategy in the context of this understanding. If you were thinking that maybe you should revisit your portfolio and investment strategy, you are probably right. Click to enlarge Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Long-Term Underperformance Of European Active Management Continues To Play Out In The Active Vs. Passive Debate

By Daniel Ung Every six months, S&P Dow Jones Indices publishes the S&P Indices Versus Active (SPIVA®) Europe Scorecard, which seeks to compare the performance of actively managed equity funds across different categories, and in the SPIVA Europe Year-End 2015 Scorecard , we expanded it to cover more individual countries and regions. Among the new additions are Italy, the Netherlands, Poland, Spain, Switzerland, and the Nordic region, with specific data for Denmark and Sweden. This is also the first year-end report in which 10-year data is published for Europe. To access the full report, please click here and for the video summarizing the major findings of the report, please click here . Global equity markets, as measured by the S&P Global 1200 , rose 10.4% over the past one-year period, as measured in euros, which could largely be attributed to the European Central Bank’s quantitative easing program. However, this apparently positive performance masked the heightened volatility that the equity markets experienced over the course of the year, which was a consequence of anemic Chinese growth, as well as the collapse in energy and commodity prices. Compared to the S&P Europe 350 , while 68.1% of active managers outperformed the benchmark over the short run, they underperformed the benchmark over longer time horizons. 63.8% of active managers underperformed the benchmark by the end of the three-year period, 80.6% in the five-year period, and 86.3% over the 10-year period. Exhibit 1 shows the new categories highlighted in blue. As for the global, emerging market, and U.S. equity categories, actively managed funds – in both euro and pound sterling – underperformed substantially in the short term (one-year category) and in the long run (10-year category). For instance, 61.2% of global equity funds underperformed their benchmark over a one-year period, and 89.08% of funds underperformed the benchmark over a 10-year period. Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .