Some of the original architects of smart beta are anxious about the market becoming overcrowded. Should investors be too? Kit Klarenberg investigates.
The ascent of smart beta in recent years has been dizzying. A decade ago, the phrase figured in the investment lexicon of only a select few. Today, the number of available strategies runs to thousands, and collectively they hold assets in excess of $600 billion. Untiringly favourable media coverage promotes them as a panacea for investors pessimistic about active managers and passive index trackers.
This upward trend shows no sign of abating, and institutions are expected to play a big role in the expansion. Research issued by ETF provider Source suggests 27% of institutional investors currently invest in smart beta, and a further 31% anticipate they will in the next two years.
Such projections are surely good news for smart beta’s assorted providers – although surprisingly, some are highly circumspect. Research Affiliates, the US indexing innovator responsible for developing some of the world’s first smart beta indices, made headlines when it issued a report expressing disquiet at the boom.
Provocatively titled ‘How Can Smart Beta Go Horribly Wrong?’, the report claims the soaring popularity of smart beta is hastening investor pile-ins to strategies that invest in already expensive factors, which will artificially inflate their valuations further and produce severe losses when prices return to more realistic levels. Performance-chasing, in other words.
Performance-chasing is a well-established issue in investment, and fears of performance-chasing by smart beta investors are nothing new. Previously, however, active managers and traditional passive providers have sounded the alarm. While their misgivings can be dismissed as wishful thinking, a key smart beta player echoing them is less easy to ignore – and the report’s conclusion that there is a “reasonable probability” of a smart beta “crash” in the near future is troubling.
Fundamental to Research Affiliates’ concerns is the notion that investors are flocking to low volatility strategies, which currently wield high valuations in historical terms. That investors are enamoured with low volatility at present is indisputable, and this affinity is logical: markets have been unstable to varying degrees since last year, and could become increasingly so.
Moreover, low volatility’s current expense is empirically demonstrable. Morningstar data suggests valuations are currently among their highest in a decade. Should smart beta investors be worried? Gaurav Mallik, global head of equity strategies at State Street Global Advisors (SSGA), thinks not. While acknowledging volatility is expensive on a relative basis, he says valuations are far from maximal – especially compared to historically high periods such as 1998/99, and the financial crisis.
PAYING A PREMIUM
Such episodes are obviously extreme, but given the increase in volatility over the past few months, he believes it’s entirely to be expected that low-volatility assets currently come at a premium. When market downturns are possibly in the offing, hedges are invariably pricey.
“I’m not sure we can call investor interest in low-volatility factors performance-chasing yet,” he says. “Assets moving into low-volatility stocks have been rising, but from a very low base. Inflows into dividend and growth-based strategies are higher.”
Nevertheless, Mallik doesn’t discount that other factors may be a better bet in the current environment. Investors might want to consider allocating more to value strategies, which he notes are currently “very cheap”.
Bernard Nelson, senior investment consultant at Jardine Lloyd Thompson, largely shares Mallik’s scepticism. While believing a strategy’s returns can be arbitraged away if more and more investors seek exposure, he doesn’t think a crash is in the offing. As smart beta strategies don’t deviate from their underlying indices too much, they’ll only collapse if their index does. The lone risk he identifies in the market is investors not receiving the level of return they’re expecting.
“This underlines the need for diversification, and not basing smart beta exposure on just one factor,” he says.
Others believe the notion that smart beta’s popularity will inevitably overload the market is based on fundamentally flawed logic. For Clifford Asness, managing and founding principal of asset manager AQR Capital, popularity is nothing to fear in the smart beta market.
“While it’d be nice to be the only one invested in a good strategy, broad knowledge of that strategy doesn’t mean its benefits necessarily disappear. Don’t assume that once something is known, it’s gone forever from that day onward,” he says.
“Returns don’t have to slide to zero, and risk needn’t reach unacceptable levels – this certainly hasn’t befallen any of smart beta’s most popular factors yet. At most, factors might become less attractive – not completely eliminated.”
If certain strategies losing their appeal is the sole upshot of rising smart beta inflows, that seems like no big deal. After all, new smart beta products are seemingly born every minute – surely it’s not hard for investors to find a new one that suits them better?
SPOILT FOR CHOICE
If only it were that easy. The reality is many strategies are very much alike – at best emphasising some similar factors, at worst being carbon copies of one another. This cluttered marketplace makes choosing complicated, and escaping certain factors problematic – but not entirely impossible.
It’s important to note that while smart beta strategies are nominally passive, they still employ investment processes, which can be analysed. Investors should undertake in-depth investigations of prospective strategies, just as they would when choosing an active manager.
“Devote due diligence to understanding the objective of the smart beta strategy, and how it fits with your views and investment goals – strategies should fit in with your overall investment objectives, the risks and return parameters based on economic and market analysis and sound investment advice,” says Sital Cheema, associate director of client strategy and research at Russell Investments.
“Also, take the time to understand the index’s construction methodology, its exposures and expected behaviour in various market environments.”
Mallik stresses the need for investors to think about “sources of return”, and whether returns come from fundamentals or valuation expansion.
“In equities, this would be the equivalent of asking whether the performance of an index has been driven by a multiples expansion, or from improving fundamentals, such as earnings per share or dividends,” he says.
Once invested in a strategy, ongoing monitoring of its performance and weightings is also recommended – as with active managers. Changes in weighting can meaningfully influence both returns and risks.
“I’ve seen some analysis which suggests systematic rebalancing – realigning portfolio weightings periodically – tends to improve a portfolio’s risk-adjusted returns quite substantially,” says Nelson.
“It’s likely a meaningful proportion of the added value of smart beta strategies stems from periodic rebalancing of the portfolio.”
Time will tell whether the smart beta market does get overcrowded, to what degree, and what the impact will be – although, evidence that strategies are becoming dangerously deluged, or could be, appears lacking for the time being at least.
While much capital has been flowing into smart beta, the money has to come from somewhere – and presumably, at least some of it’s being transferred from active managers with a bias to the same factors smart beta strategies invest in. This surely produces equilibrium in the market, not destabilisation.
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