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.\”
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If every investor adopts a method, it becomes the market. The continued persistence from the risk premiums associated with factor index ETFs depends upon someone else being on the other side from the bet, Johnson said.
A good example in the current environment is the massive crowding of dividend ETFs. As ever more investors buy in, the chances the factor can lead to outperformance diminish.
Raman Aylur Subramanian, MSCI managing director and head of Index Applied Research for that Americas, pointed out in a presentation titled Factor Indexes Made Simple that top 10 Canadian pension managers use smart-beta products.
He once looked at active managers that had a history of generating consistent alpha. A lot more than 65 per cent of the outperformance came from stock selection, but factors or smart beta could explain a lot of it.
MSCI\’s Barra unit looked at all factors that explain stock market performance and also the six key ones were low size, value, quality, momentum, yield and low volatility. Tilt the MSCI All-Country world index, which has returned 8 percent since 1993, to any one of the six factors and you can generate a better risk/return.
That\’s what attracts investors, but it\’s not a free lunch. As Johnson noted, there can be sharp reversals on the full business cycle.
In the late ’80s and ’90s, size and value did not do well, while quality did best. Value, momentum and low size are pro-cyclical towards the business cycle, while quality, low volatility and yield tend to be more defensive.
In the current market, low volatility and quality are doing well. In the last 20 years, the standard factor has been doing better in recessions, as has low volatility (a.k.a. low vol), but when there\’s great news and everyone is bullish, \”quality will not be doing better,”?Subramanian said. “Advisers shouldn\’t bet on a single pony. Use multiple factors.\”
Quality is the most misunderstood element in the market. Some think it\’s just another version of value, but it\’s completely different.
\”Value is companies you think are cheaply priced versus market pricing. Quality goes beyond value,”?Subramanian said. “Quality companies have durable business models and sustainable competitive growth advantages. Quality growth stocks outperform the market with relatively low volatility over long periods.\”
He pointed out that Warren Buffett\’s performance can be explained by three factors: value, quality and low volatility. \”He buys cheap stocks with quality.\” Of late, quality has done very well in Europe.
Next time, we\’ll look at two Canadian ETF manufacturers built around factor indexes: First Asset and First Trust.