Smart Beta Dumb Alpha?

Bev Durston

Factor investing is with us to stay. But what’s in the tin? And is there a better way to realise its promises?

Factor investing has come of age, with nearly 50% of $1 billion-plus asset owners already invested and over $400 billion in the US in smart beta exchange-traded products.

From their beginnings as single-factor portfolios - think Value, Momentum, Quality and Low Volatility, they now number more than 300, extending to hedge fund-like strategies such as long-short, foreign exchange carry, merger and convertible arbitrage that use pre-defined screening rules with automatic implementation. Rather than being used in single factors a significant number of products (64%) are created using a variety of factors.

The area has grown substantially and you can see why: quant screening, automatic implementation and mostly static portfolio holdings are cheap to deliver – very enticing when budgets are tight.

Here are six things you should be cautious about with this area:

  1. Don’t believe the back-tests. It is pretty easy to trawl past data to find a “profitable” strategy. David Leinweber and other researchers at Stanford Business School demonstrated this in a persistent relationship between S&P500 returns and a cocktail comprising annual butter production in Bangladesh, the US population and annual US cheese production! The only true, out-of-sample, test is the future.
  2. Crises happen more and more often. Black Monday on 19 October 1987, the Quant equity crash of August 2007, convertible arbitrage funds in 2008 were all due substantially to automated implementation without over-rides – aggravated by many investors chasing the same trades.
  3. When the regime changes you need to be flexible. And we could be facing one now, as central banks tighten. But adapting quickly is hard to do when you are tied to passive implementation.
  4. Ask hard questions about agency risks: Where do they come from? Who makes money from them? Many alternative beta strategies originated with investment banks and hedge funds but, as proprietary trading becomes more expensive, investment banks are re-packaging them for institutions and retail investors. They make money, not from performance, but from asset gathering. They also rely on leverage, as MERFX, a long-running U.S. merger arbitrage mutual fund shows. With a three-star Morningstar rating, 25 years up and only three years down, its 28-year history is 2.4% annualised with 3.3% risk, giving a Sharpe ratio of 0.6. The expense ratio is 1.4%. Without leverage, this is hardly a wonderful investment.
  5. “Smart beta” makes dumb portfolios. Factor portfolios are essentially indices over-weighted to one or more particular factors. Unlike portfolios, factor indices neither maximise risk-adjusted expected returns nor reflect risk-adjusted returns. What’s more, they are often over-diversified and trade too much.
  6. Factor investing is high maintenance. To do it well you have to manage each of nine steps:
    • Select the factors
    • Select the universe
    • For a multi-strategy portfolio, weight each factor and maintain covariances
    • Arrange and apply leverage
    • Manage counterparty risk
    • Rebalance
    • Implement on-off switches or stop-losses
    • Monitor for decay
    • Monitor for regime shifts

    This is more like an active alpha strategy, a complicated task for an institutional investor.

Factor investing, smart beta and risk premia investing are definitely here to stay and will surely become more popular. But their promise of precisely-targeted investment exposures at attractive prices may not always materialise.

Is there a way to achieve these objectives while avoiding the risks?

You can start by looking hard at the strategy. Remember that a strategy’s popularity can herald its downfall. Question what lies behind the marketing pitch and bear in mind that the last person in is often the one who suffers most in crowded markets.

And consider alternative assets: they offer many of the benefits of smart beta and avoid some of the worst pitfalls.

You want to target and diversify your risk? Private debt funds that invest in clearly-defined market segments do exactly that. No back-tests needed.

Worried about crises and crowded trades? What could avoid them better than a fund that lends directly to under-serviced firms?

Concerned about regime change? Private debt held to maturity not only sails through it, but, well structured, will deliver powerful downside protection too.

Agency risks worry you? With private investments, you see every deal from start to finish.

Unlike many smart beta products, private markets give you what is written on the tin: transparent investment exposures, a true buy-and-hold investment plus alignment of interest in focusing on performance fees for hard to access, complex transactions.

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