The Argument Against Smart Beta Strategies

Jun.11 — Vincent Deluard, INTL FCStone Financial Inc. global macro strategist, explains his argument against smart beta investment strategies. He speaks with Bloomberg’s Scarlet Fu and Sarah Ponczek on “What’d You Miss?”

You were once a fan of smart beta but something ruined it for you what what happened why have you turned against it is it just because there’s too many of them it could be i mean one thing is that it could be that there was nothing to start with i mean keep in mind that there are literally hundreds if not thousands of factors that can be data mined so if you dress

Focus on let’s say the five percent of top performing factors you’ll find some of them that will perform well even though there’s nothing there just out of sheer statistical luck money could be another issue as you point out we have about 800 billion in assets in small beta ets from close to zero ten years ago and every time you see a trillion dollar go into a

Certain strategy or certain type of strategies things and in tears i think one thing that investors need to look at when they evaluate these strategies are these valuations grab our sorry go ahead no no i think that’s a really good point before we get to valuations sarah vince obviously not the only one who is a little bit suspicious and skeptical here rob arnott

Who is one of the founders of smart beta factor investing is also a little bit skeptical too he mentioned some big numbers here give us a sense of how quickly smart beta has grown and if that’s where all the growth is especially in the equity etfs right exactly vince is definitely not the only skeptic you will always have your skeptic and rob arnott who’s curiously

One of the founders of smart beta he echoes a similar thing to what vince was just saying that valuation issue he put out a paper about two years ago that really caused a ruckus basically saying that part of the reason that these strategies are really succeeding is just because they’re increasing in popularity and as more cash goes in that inflates their valuations

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And ultimately one day they’ll they’ll crash and we have seen that pick up in popularity although there is still more room to grow right now assets under the whole us smart beta umbrella are nearing that 800 billion mark that’s nearly tripled from 2012 black rock actually estimates that that will reach 1.4 trillion by 2022 so we’re still seeing some pickup there

And it’s mostly right now in equities but the next frontier as the issuers say really is that fixed income smart beta space yeah so that breakneck pace is certainly concerning vince we mentioned you went out to build your own dump portfolio what he did was to include companies that were excluded from smart beta funds in general and you compared their performance to

An index made up of five smart beta funds that are equally weighted damned reaper of invesco powershares said that the etf’s in your test were kind of a hodgepodge i want you to listen to what he had to say i think being able to look at the s&p more of a pure style exposure which which we offer at invesco and we did the same analysis we had 23 years of data we

Ran it we found that this hodgepodge of equal weighted only outperformed 8 out of 23 years but using our s&p you know more pure factor exposure outperform 16 out of 23 years means how do you respond to dan’s evidence that they’re pure factor exposure outperformed i mean it could be at any at any point in time you will have some factors that outperform i mean

Keep in mind if you slice the market in 50 ways about 25 of these ways will outperform the market so it could be that his specific ets have done better now i can respond for me is i only took the most well-known academic anomalies and i used a lot respond for each one of these categories focusing on the s&p 500 index and that’s how i ended up with my list of

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5 warren court small beta ets now of course at any moment some small beta etf will outperform i mean one thing that we’ve seen for the past two years is the very firm performance of momentum etf partly because the fang have done so well but again how likely is it that you would know in advance which fact or which factor is going to perform well if you would know

That you would just buy the thing so i think my approach of just being agnostic and equal weighting the five main anomalies was the right one vince yes i do want to jump in when i spoke to a lot of the market participants there were three caveats that really did stick out one of them of course was time now you don’t have the luxury of time because i know that you

Started the experiment right before the presidential election in 2016 so we’re not quite at that three-year mark a second one was that different factors are supposed to work in different environment so you wouldn’t necessarily take those five and maybe equal weight them and then another one that was put out there was the idea that you don’t necessarily want to

Buy a factor to beat the market at all times maybe you want to buy one to reduce volatility maybe you want to buy one to boost income in a way so i’m just curious what your response to that is as well well i i mean part of it is true and part of it is a really musing cause in many ways this is exactly the argument that classical active managers give once they start

Out performing you know old school stock pickers say well you shouldn’t bias for the performance but for the diversification so it’s quite amusing to see an etf industry that has for so long dismiss these claims as ridiculous embrace them so that would be my answer vince one thing that you point out is that all these different smart beta strategies are correlated

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To falling yields and the environment that we’ve had for the last decade is low interest rates are falling yield so now that we expect the federal reserve to continue raising interest rates that we’re in a rising rate environment how do you expect smart beta strategies to perform going forward i think this is a crucial point that you made here and i think that’s

A general problem with any sort of quantity strategy is that for the past 30 years we have seen falling yields i mean from 18% of the fed funds around 1981 to 0% following the great financial crisis and really most baptists have to focus on that period it’s very hard to run a backtest before that because you don’t have good data so all the factors that come out

Of the zoom machine are likely things that look like bonds like low volatility high earnings predictability free cash flow generation high dividend high buybacks so every single factor that you see come out now is a hidden that on interest rates and i think one thing that investors need to ask is how like is it that this will keep outperforming in a rising rate

Environment and this is something that quant studies backward-looking quantities cannot answer and vince mentioned the factors ooh and i think that’s something that people kind of job at a little bit as an interesting phrase you may call it but basically the idea there’s a lot of different factors out there and there might always be discussions and there might

Always be new research coming out about a potential new factor i was just at the inside smart beta conference last week here in new york and there was an interesting panel and two of the panelists actually got in a bit of an argument over whether or not momentum is actually real factor also discussing liquidity whether that is a real factor or if it’s just another word for size

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The Argument Against Smart Beta Strategies By Bloomberg Markets and Finance