PERFORMANCE: The all-weather fund?

It’s often asserted that multi-factor smart beta strategies can perform in all market conditions, but are such forecasts credible, or pure hot air? Kit Klarenberg investigates.

The ongoing search for an all-weather investment strategy very much recalls the quest for the Holy Grail; while the object of desire may in fact be mythical, given the spoils many feel it worth pursuing anyway.

For years, this expedition was the exclusive preserve of the active sphere; traditional passive funds, which mimic market cap weighted indexes, cannot by definition perform in all market conditions. Their returns are but a reflection of a particular market’s standing at a given time.

The years immediately following the financial crisis of 2008/09 saw the proliferation of absolute return funds that specifically aim to deliver positive returns no matter the state of the market, and invest in any and all assets to do so. While popular with investors (in the UK, the sector has been a bestseller several years in a row), they have often failed to live up to their professed raison d’être; according to Morningstar data, around 66% of funds in the sector posted negative returns last year.

Nevertheless, the hunt for an investment strategy that can perform in every market condition persists. Increasingly, smart beta strategies are seen as the solution, as they invest in fundamental underlying investment factors, rather than traditional assets or market indexes.

Individually, smart beta factors can be as subject to cyclical underperformance as market cap weighted approaches. A study published by S&P Dow Jones Indices in January this year analysed smart beta’s eight ‘classic’ factors – growth, liquidity, momentum, quality, size, value, volatility and yield – between 1994 and 2014, and found periods of significant underperformance in certain circumstances. For instance, value and yield had a tendency to underperform the market during prolonged market rallies, growth significantly lagged even passive index funds during bear markets, and volatility underperformed against the market during rebounds.

The theory goes, however, that these separate factors, which complement each other’s strengths and offset each other’s weaknesses, enable smart beta indices to capitalise on the positive elements of the market, no matter its overall state.

“The advantage of a multi-factor approach is the diversification gained from spreading risk across factors that tend to have low historical correlation with one another – so when some factors are down, others may be up to compensate,” explains James Waterworth, vice president of ETF sales for UK & Ireland at Lyxor Asset Management.

If this thesis is correct, then the ever-expanding number of identified investment factors greatly increases the chances of constructing a four-season investment strategy; there are about 350 factors for investors and investment managers to choose from, and more are being discovered all the time.

Some point to smart beta indices’ record of outperformance in recent years as proof these vehicles can deliver year-long positive returns: ETFGI figures suggest smart beta indices have outpaced their cap-weighted counterparts by the order of around 5% on average in the past five years.

HOT AIR FORECASTS
For many, though, question marks hover over smart beta’s ability to perform whatever the weather. Even some of its practitioners are sceptical. “By combining strategies, it is indeed possible to improve returns in response to a range of market conditions, but investors should avoid the misperception such a combination could produce an absolute return profile,” says Antoine Moreau, deputy chief executive of Ossiam.

Laurent Trottier, global head of ETF, indexing and smart beta management at Amundi, agrees. He even suggests constructing a smart beta strategy that can perform in all market conditions isn’t a desirable objective.

“Smart beta strategies should be transparent and straightforward, but the more factors a strategy has, the more complicated and opaque it can become,” he says. “Adding a well-diversified mix of filters in a strategy could be a useful solution, in order to avoid overexposure to a single factor. Indeed, a strategy being too simple has its own risks. For instance, a low volatility smart beta strategy cannot be based on low volatility alone; a pure approach would potentially produce concentration risk, as its portfolio would focus on a limited number of sectors. In this case, adding further layers is sensible and necessary, as it would improve the strategy’s performance.”

With 350 factors to choose from, achieving diversification may seem no tall order – although, the validity of many of these mooted factors is disputed in some quarters. Ian Webster, chief operating officer of Axioma, feels investors are best sticking with ‘classic’ factors when constructing a smart beta portfolio. The ability of these elements to outperform is supported by a wealth of academic literature – the other 342 are less well buttressed.

“Some have even suggested many of the new factor premia are the product of data mining – i.e. if you look hard enough, you can get the data to tell you what you’d like to observe,” he adds.

The historical grounding of many smart beta factors is, for others, another argument against its all-weather capabilities. Yves Choueifaty, founder of smart beta pioneer Tobam, says predicting with certainty which factors will outperform, much less perform in all market conditions, isn’t feasible on this basis. “Smart beta strategies are not forward-looking. Factors are identified on the basis of historical analysis – thus, they are chosen on the assumption they will continue to outperform. As with traditional passive and active investment strategies, past returns are no guide to the future – and if underlying economic or market conditions change, returns can vary significantly,” he says.

The picture is complicated by the market milieu witnessed since the financial crisis. While markets have been typified by uncertainty, volatility and major fluctuations since then, especially in the past year, they have overall enjoyed a moderate bull phase. Whether smart beta can consistently outperform, or even post positive returns, in the midst of a proper downturn remains to be seen.

OUT WITH THE BATHWATER
Nonetheless, it would be wrong-headed to assume every investor piling in to multi-factor vehicles assumes they’ll receive year-round returns. Likewise, that smart beta cannot perform in all market conditions doesn’t negate its worth as an investment approach.

These strategies still offer investors a unique, low-cost investment proposition, which delivers a level of outperformance typically provided at great expense by active managers and hedge funds. For retail and institutional investors, this is an inexpensive solution to the problem of a low-return, low-yield environment, which looks set to persist for the foreseeable future.

Although, it may be premature to definitively say smart beta cannot perform in all market conditions. The approach is in its relative infancy; while a new name for a well-established investment approach, long-employed by institutions and certain active managers, its practitioners have only just begun to consider its applications to other investment markets, such as fixed income. Product design is also embryonic when compared with market cap weighted passive vehicles.

As the market evolves and grows more widespread and sophisticated, there is perhaps the potential for smart beta to make good on the promises of some providers, and fulfil the hopes of investors. Still, it may be years before this potential can be confirmed either way – until then, investors will have to settle for the mere prospect of not only year-long smart beta returns, but consistent outperformance. In the meantime, the pursuit of the Holy Grail continues.

©2016 funds europe