AQR Co-Founder Cliff Asness—like many in the industry—has long had a bone to pick with “smart beta”.
“I think people should call a bet a bet,” he wrote in a 2010 article on his “Top 10 Peeves” about investing and finance. “Some of the discussion these days about ‘smart beta’ refers to it as “a better way to get market exposure.” It’s not… If you own something very different from the market, you’re making a bet and someone else is making the opposite bet.”
And, like most large asset managers, Asness has come around.
In an upcoming article for Financial Analysts Journal, Asness and firm Co-Founder John Liew have contended that smart beta strategies are not new, nor are they beta, but are “still awesome.”
AQR’s founders “believe certain factor tilts work reliably over time” to deliver value-add over capitalization-weighted indexes, according to the paper. Simple versions of smart beta “can be understandable, transparent, and available at a reasonable fee,” Assness and Liew continued. “We believe there can be tremendous value add to this undertaking and we’re here to praise, not bury, smart beta—but only after an honest understanding of it.”
- Source: AQR
First of all, the authors stuck by Asness’ 2010 assessment and reiterated that factor-based funds are decidedly “active strategies in the sense of trying to outperform.” For this reason, Assness and Liew argued that investors shopping for say, a value-tilted US equities product, should not select one based on fees alone as they might for a traditional index fund.
Furthermore, they felt that the traditional single-tilt, equities-only approach of smart beta products fails to fully capitalize on the theory underpinning the entire strategy.
Examining the historical performance of value, momentum, and profitability factors, the authors found that “these styles’ excess returns tend to be lowly correlated with one another, with performance often coming at different times… Diversifying across various smart betas can and has provided a more consistent way of beating a traditional benchmark.”
- Source: AQR. Based on long-only hypothetical returns for the US large cap universe, approximately corresponding to the largest 1,000 US stocks by market capitalization. Returns are gross of fees and net of transaction costs.
Asset owners could diversify their factor exposures through a basket of various single-tilt funds or pre-made multi-strategy products. Given that AQR offers primarily multi-tilt products, it is perhaps unsurprising that Liew and Asness recommend that approach.
Allocating to several risk factors in one product lowers transactions costs, gives investors access to stocks that excel on several counts—but may not pass muster on just one—and improves managers’ control over portfolio-wide risk levels, the authors argued.
But integrated products come at a cost often greater than single-factor strategies, they acknowledged. Furthermore, “they generally involve less diversification across managers and less explicit end-investor control of factor exposures.”
Perhaps most importantly, Asness and Liew pointed out, while fixable with transparency, “the multi-style tilt does lose some of the beautiful simplicity that may have first attracted investors to smart beta.”
Related Content: Feature: The Smart Beta Tragedy; AQR: Hedge Fund Finalist for 2014 Industry Innovation Awards