If active management is facing an existential crisis, smart beta would appear to be in the ascendant. But things are never that simple.
In fact, smart beta is facing a crisis of its own – an identity crisis. This crisis might not be of the same magnitude as the challenges facing some traditional active managers, but there’s still reason to be concerned when no-one can agree on what constitutes a smart beta fund.
The debate runs deeper than nomenclature, and encompasses how indices are weighted, which factors are used, how many factors exist and whether it's possible to time factors.
Last December the ‘godfather of smart beta’ – Rob Arnott, founder and chief executive of Research Affiliates – told Citywire he was concerned the term was being misused.
‘The factor landscape has embraced the term smart beta, but I disagree,’ he said. ‘You start with a cap-weighted market and put a tilt on it, so you are still linking the weight to the price. That’s the Achilles' heel of cap weighting. Why would you want to own more of something after it doubles than before?
‘But I am losing that argument,’ he said. ‘The market seems to think that anything systematic is smart beta, even if it’s cap-weighted and very expensive relative to its historic norms.’
Fast forward six months and the argument is still in full swing. It dominated discussion at the 22nd Annual Global Indexing & ETFs/EBI West conference, which took place at the end of June in Dana Point, California.
‘We’ve seen a lot of providers of the products, not just ETFs, trying to use strategic beta or other terms. It’s kind of like Kleenex. I think everyone kind of put their hands up and said “OK we will use smart beta…” There is huge confusion with the term,’ said Deborah Fuhr, managing partner and co-founder of ETF research consultancy ETFGI.
Mannik Dhillon, president of ETF shop VictoryShares, said firms needed to be more honest about rules-based or factor-tilted strategies.
‘I think the world is calling it smart beta but it shouldn’t be. It’s OK to call it active but rules-based,’ he said. ‘We don’t have to call it smart beta or strategic beta [just] because we are doing something different from the benchmark.’
James Montier, a member of the asset allocation team at GMO, pulled no punches in his assessment of the term, arguing that smart beta was dumb beta with smart marketing.
Spoiled for choice
This was not the only point of contention during the two day conference, with industry heavyweights split on how many factors existed and how they should be used.
Arnott took to the stage and claimed there was an ‘academic bubble’ in factor research. He said one professor had recently claimed there were as many as 316 factors.
Arnott remains skeptical about how robust many of these actually factors are despite, or even because of, the research behind them.
He argued that selection bias and data mining in the research meant that many of these factors would not work in practice.
‘If you are a professor looking for tenure, how likely is it that you are going to publish a factor that doesn’t work?’ asked Arnott. ‘Are the odds of that zero? Yeah, I think so.’
‘I asked [the professor] how many of the 316 factors worked, added value, provided an indication they could beat the market. He laughed and said that 316 showed that,’ said Arnott.
‘Well you know if 316 out of 316 worked, that’s fantastic, it means we can stop thinking, turn our decisions over to computers, let factors run our money and it’s going to work,’ he joked.
Craig Lazzara, global head of index investment strategy at S&P Dow Jones Indices, was also skeptical about the number of factors. ‘There are not 500 factors or 358 factors, that’s rubbish,’ he said. ‘There might be five or 10. There may be many manifestations of a factor. You think of value as a factor, it manifests itself in yield, it manifests itself in price-to-book, earnings-to-price, price-to-sales, dividend. There are lots of ways and it’s like facets of a diamond.’
No conference on smart beta and factors would be complete without some sparring between Arnott and his regular slugging partner Cliff Asness, founder of AQR Capital Management. Sure enough, this one delivered.
While Arnott believes that factors can become expensive and that investors can time their factor investment, buying cheap and selling high, Asness believes that factor timing is difficult, does not add as much value as Arnott suggests and that diversification is a better way for investors to benefit from factor exposures.
Arnott told the conference: ‘Most investors already practice a form of factor timing, a form of market timing. It’s called performance chasing and it’s in the wrong direction.
‘If instead of doing this, we emphasize factors or strategies that are trading cheap relative to their own history [rather] than emphasizing factors or strategies that are trading rich, we have an opportunity to add some value.’
Asness was not at the event, but reacted to Arnott’s speech on Twitter.
‘While I still think he exaggerates a fair amount, value timing value is where Rob and I disagree least,’ he wrote.
In response to an Arnott paper published last year, in which he argued that all factors other than value looked expensive, Asness published a research paper suggesting that ‘one should be wary of aggressive factor timing. Instead, investors are better off identifying factors they believe in, and staying diversified across them, unless we see far more extreme pricing than we do today.’
So far, so cordial. But things heated up when Arnott argued that many academics were trend chasers and that the factors they wrote about did not add significant alpha after publication.
Asness tweeted: ‘Usually this stuff upsets me and I go nuts. Bad. But what do you do with a guy repeating falsehoods when he knows or should know better? He then quipped: ‘Well, of course, one option is to elect him president.’
One man who was in agreement with Arnott was DoubleLine Capital’s chief executive Jeffrey Gundlach, with both men sounding the alarm on low volatility.
Speaking at the event, Gundlach cautioned investors to avoid complacency despite the CBOE Volatility Index – Wall Street’s gauge of fear in the market – falling to historical lows.
‘People don't lose money due to risk, because they are ready for it. People lose money when they believe they are invested safely,’ he said.
‘For now, it’s OK to dance the risk dance but make sure you dance near the door,’ said Gundlach, who compared the current market environment to that of 2006.
His comments echo those he made on a conference call earlier this month when he warned that the days of low volatility would not last forever. He cautioned investors to prepare for a summer correction in US equity markets, while still being bullish in the long term.
‘The days of low volatility are probably numbered,’ he said at the time. ‘If you're a trader or a speculator I think you should be raising cash today – literally today. If you're an investor you can easily sit through a seasonally weak period.’
Arnott was on the same hymn sheet.
‘If you are paying twice as much for low-beta stocks as for high-beta stocks, how much cushioning of the downside risk do you really think you are going to get?’ he asked.