The mirage of smart beta

Your advisor or financial institution is offering you an exchange-traded fund (ETF) that, based on historical data, is expected to outperform the stock market index. Sounds too good to be true? It is!

To understand what drives fund managers (and your financial institution) to offer you these "smart beta" ETFs, we must recall what has been happening in the fund management industry for the past few years.

An existential crisis

These are tough times for fund managers - the firms that manage your assets and those of pension funds and mutual fund companies. Indeed, it is now well known and documented that 80% to 90% of them underperform the stock market indexes[1]. Investors (pension funds as well as individuals) are therefore turning more and more to indexed investments that offer the same return as the stock market index (including dividends) for a fraction of the fees charged by traditional managers (2.30% for the average Canadian mutual fund[2] compared to less than 0.15% for the average index ETF).

While the advent of index ETFs is great news for investors, it's quite the opposite for fund managers who are seeing their profits melt away. For them, it's an existential crisis.

Smart beta to the rescue

In this context, a growing number of managers are launching smart beta ETFs that - for a fee of about 0.50% to 1.00% - promise to outperform the indices. This is less profitable (for the manager) than a 2.30% fee, but it is still much better than 0.15%!

What is the smart beta?

The term "smart beta" refers to investment strategies that aim to generate better returns for a given level of risk (or less risk for a given level of return). These strategies typically exploit market "anomalies", such as:

• Momentum: stocks that have risen the most in the last year tend to continue to rise over the next year
• Value: securities with "value" characteristics (e.g. low price-to-book ratio) tend to beat the market
• "Low volatility": less volatile securities tend to offer better long-term returns (contrary to what financial theory predicts)
• "High dividend: high dividend stocks also tend to beat the stock market over the long term

These "anomalies" have been identified by analyzing stock market databases covering several decades. The existence of the momentum effect, for example, was documented by two finance professors, Narasimhan Jegadeesh and Sheridan Titman in 1993[3]. Since then, several other "anomalies" have been identified and are now being exploited by an ever increasing number of ETFs.

How does the smart beta work?

The first investors and managers to exploit these anomalies were successful. Among others, AQR Capital Management in the United States and Jean-Luc Landry in Canada generated returns that exceeded stock market indexes in the 1990s and into the early 2000s by exploiting the momentum effect.

So, yes, the smart beta did work...but it doesn't work anymore!

Why is this?

Charter flights to deserted beaches

To answer this question, I will use an analogy: that of a deserted beach. The market anomalies behind smart beta strategies are - or rather were - like deserted beaches: a few adventurers knew of their existence and could therefore take advantage of them (literally!). But when academic studies were published showing the existence of these anomalies everyone started to exploit them. Like a deserted beach that is suddenly overrun with vacationers is no longer deserted, the market anomalies that everyone is trying to exploit have stopped working. Taking the analogy a step further, smart beta funds are like charter flights to (no longer) deserted beaches!

The numbers don't lie

To convince yourself that smart beta strategies no longer work, just check out the S&P Dow Jones website, which publishes an index for each of the major strategies[4]. Before fees, only 6 of the 16 strategies tracked by S&P Dow Jones have (slightly) beaten their index in the last 3 years. However, if we subtract the implementation costs of these strategies (due to its high turnover rate for example, momentum can generate costs of more than 3% annually) only one of these 16 strategies has been running for 3 years. The 2 oldest of these strategies - value and momentum - have generated returns below the indices for 15 years, before fees!

Even worse, these strategies can be subject to these dramatic reversals. The "high dividend" and "low volatility" strategies for example (the most popular until last year), have made -8% and -11% against the index over the last 4 quarters! It is no coincidence that these strategies are experiencing such reversals: the influx of funds into these securities pushes their price to a level from which they can only come down. We call this a bubble!

The real smart beta!

True smart beta is what the markets deliver, year after year. It costs only 0.15% in fees (some index ETFs have fees as low as 0.05%!) and allows you to beat 80-90% of fund managers. That's smart!

Archer Wealth Management

Archer Wealth Management offers an alternative to large financial institutions and mutual funds. We are independent financial advisors and use an index-based approach to structure a diversified, customized portfolio that minimizes risk, costs and your tax bill. Archer is registered with the Autorité des marchés financiers.

1]S&P Dow Jones Indices: http://us.spindices.com/spiva/#/reports

2]Morningstar, Global Fund Investor Experience Study, June 2015

3] Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Narasimhan Jegadeesh and Sheridan Titman, The Journal of Finance, Vol. 48, No. 1 (Mar., 1993), pp. 65-91

4 ] S&P Dow Jones Indices: http://us.spindices.com/indexology/smart-beta