Chasing beta can get better results, but not without discipline

Chasing beta can get better results, but not without discipline

Often said smart beta is in danger of getting frightfully silly. The fund management industry’s brightest idea of the past few years has opened the real chance to improve returns and reduce costs.

Smart beta is the term for funds using techniques developed by passive index funds to make active attempts to beat the market. Some take standard stock market indices, which are weighted according to their market value and reweight them according to fundamental characteristics, such as the dividends paid, or the sales they make.

Others aim to harness the investment anomalies or factors that have outperform the market in the long term. The most popular include value, stocks that are relatively cheap when they are bought and outperform over time, momentum winners tend to keep winning while losers keep losing, and size smaller stocks tend to beat larger stocks.

Like index funds, their costs are low, with lower trading costs and little need to pay for ongoing research. And yet they stand a good chance of beating the market. This makes them an intelligent improvement on traditional actively managed funds, which often traded on these same factors, but in a less systematic way.

The problem is that as the industry sells smart beta funds, and investors buy them, they are in danger of committing the same mistakes.

The first issue is data mining. As the arms race to find new factors continues, historical data are being tortured. When a factor is publicized, and a fund launched, it tends to have performed well in the past even though there were no funds in existence to follow it. In practice, their strategy is shown to have great performance at the point of publication.

A separate problem is timing. Over a long period, valuation gives an idea as to what might be best to buy at any one moment even if it gives no help to identifying a top or a bottom. If a stock or bond is expensive, compared to its own history, it is a good bet that it will perform worse over the following years, and vice versa.

The same applies to factors. Some factors perform well at times when others do not. Buying a factor when it is relatively expensive when the stocks it contains are relatively expensive compared to their historical norm, is as bad an idea as buying a stock when it is expensive.

According to extensive research, a strategy within US stocks of continuously buying the three most expensive factors would have unperformed the market while continuously buying the three cheapest would have beaten the market by 3.7 percentage points per year. This looks like a plausible model for funds that could form the backbone for long term pension savings.

But here lies another problem; performance chasing. The fund industry revolves around looking for the funds that have performed best recently. It is always a safe thing for an adviser or consultant to recommend.

Quite an industry is developing around timing and recombining factors. It risks falling prey to the same mistakes made by the active equity management industry.

None of this means that smart beta is not smart, as first advertised. The logic behind exploiting market anomalies in a systematic way and reducing the costs in the process, remains intact. But such strategies work primarily because they impose a discipline to avoid the endemic errors that we tend to make, both because of our own psychology, and because of the perverse incentives at work on the sales practices of the investment industry.

We risk using smart beta funds to make endemic errors in a new way and with the Sensex almost at the all-time high and valuation of stocks looking stretched a number of fund managers are looking at chasing the beta to get the extra return but need to be extremely discipline in their overall approach.

_Farzan Ghadially