Jonathan Chevreau: The lowdown on ‘smart’ investment funds

Over a full market cycle, there will be times when smart-beta strategies won\'t feel smart (i.e., perform well) relative to standard market-cap-weighted or actively managed funds.

There\’s a perception among exchange-traded-fund investors that traditional broadly diversified market-cap-weighted money is the \”old guard\” and newer \”smart beta\” or \”factor index\” goods are the wave of the future.

But as various speakers at a BMO ETF and mutual funds conference in Chicago in April explained, so-called strategic beta products often constitute old wine in new bottles.

Ben Johnson, who does passive funds research at Morningstar, told the crowd that the term strategic beta was featured so long ago because the May 1978 cover of Institutional Investor magazine, featuring Barr Rosenberg, founder of the Barra indexes.

\”Smart beta is a misleading term,\” Johnson said. \”We\’re talking about a category of strategies that isn\’t necessarily always smart. It\’s still incumbent on advisers to know the nuts and bolts of index construction.\”

More to the stage, over a full market cycle, there will be times when these strategies won\’t feel smart (i.e., succeed) relative to standard market-cap-weighted or actively managed funds. \”Each has unique performance cycles of under- or over-performing relative to the benchmark or to each other,” he explained.

Once that\’s understood, there\’s the risk that investors won\’t use these strategies well over the full market cycle. If the promise of a danger premium is excess returns over a long period, there is an assumption that investors will stick to the strategies for a long time and not abandon them, Johnson said.

So, no surprise, \”behaviour is the most important factor to control in implementing these strategies for clients.\”

Another important lesson is the fact that investors shouldn\’t pay active prices for passive funds that needs to be available at a low cost. \”If one data point can be shown to predict future performance, it is cost,” Johnson said.

A further consideration is capacity risk, since the very popularity of factor funds could have the seeds that belongs to them destruction. As more investors herd into the most popular strategies, expected investment returns diminish – a phenomenon called \”factor crowding.\”