Does Smart Beta Deliver Superior Performance?
Art by Jon Han
So how smart is investing in smart beta, anyway? These strategies, designed to supplant traditional cap-weighted indexes, are increasingly popular. The inherent promise in smart beta is that it will outperform a conventional index like the S&P 500 or some other such market-value-based benchmark.
And some smart beta offerings will do that—for a while. But smart beta hasn’t shown that it is superior consistently.
That’s the conclusion of a Morningstar study, in which the research firm’s director of global ETF research, Ben Johnson, wrote: “Despite their advantages, on average, these funds aren’t a clear improvement over their cap-weighted counterparts.”
What they do produce is a risk/return profile that differs from the market, Johnson explained, and like actively managed funds “will experience cycles of relative out- and underperformance.”
Smart beta uses alternative metrics like earnings or dividend growth to weight allocations. Yet while smart beta is gaining investor inflow, it is unlikely to elbow aside cap-weighted products, since its purported magic is spotty, at best.
The fortunes of different smart beta plans indeed have varied over time, as recent statistics and back testing indicate. Value, size, and momentum styles would have outperformed from 1964 to 1981, John Rekenthaler, Morningstar’s director of fund research, has pointed out. Value and momentum continued to do well from 1981 to 2009. Once the market hit bottom in March 2009 through the end of 2015, however, all three approaches lagged.
Nevertheless, the number of US smart beta exchange-traded funds (ETFs) has more than tripled over the past 10 years. The expansion overseas has been similarly robust, with worldwide assets under management reaching $797 billion at the end of 2018, according to Morningstar.
The largest smart beta strategies are value, growth, and dividends. Value seeks to find gems in overlooked stocks, growth aims to ride the bull market especially with the tech names, and dividends are appealing in a time when fixed-income interest rates are low.
Also gaining notice are low-volatility smart beta ETFs, which are appealing after two wrenching market corrections last year, not to mention periodic downdrafts like last Friday’s. Momentum strategies are getting attention, too, as they look for stocks with sustainable price appreciation, a valuable quality in a bull market.
The idea of smart beta is that it’s a middle ground between index investing, where a fund automatically tracks an index (with a “beta” of near 1.0, meaning it is aligned closely), and active management, in which managers and analysts pick stocks, often based on their own rules—such as searching for shares with dependable earnings growth and a low price-to-sales ratio.
Smart beta portfolios set up a series of these rules, also known as factors, and plug them into their stock selection matrix, in effect constructing their own indexes. Following these rules means that a smart beta fund can adopt the cost-conscious edge that passively managed index funds enjoy, due to less need for expensive research and trading.
Although it’s true that most actively managed mutual funds don’t beat their index benchmarks—in 2018, 69% of actively managed domestic mutual funds failed to do better than the S&P 500—a batch of active funds do deliver. And often they do so by employing their own factors.
Consider Fidelity Magellan under the great Peter Lynch, who took over the mutual fund in 1977. During his 13-year tenure, Magellan became the largest fund in the world. Lynch’s factors allowed Magellan to blow away the S&P 500 every year. He looked for stocks with strong cash flows, below average debt-to-equity, and strong PEG ratios (price/earnings multiples to expected earnings growth).
Where Smart Beta Came From
Factor investing has been around for a long time. Back in the 1950s, for instance, an academic paper recommended selecting stocks by their price/earnings ratio. In 1991, money manager Michael B. O’Higgins hatched the Dogs of the Dow theory: The notion was that each year you own the 10 highest-yielding stocks of the Dow Jones Industrial Average, which means the 10 worst-performing, and odds are you’ll come out ahead. The strategy doesn’t always work, but it does often enough.
Rob Arnott, founder of Research Affiliates, wrote an influential paper in the wake of the dot-com bust, which advocated severing the links between market capitalization weighting and investment decisions. He calculated that indexes following the precepts of smart beta (he did not call it that then) did better over the previous four decades. Weighted by such metrics as book value and sales, rather than market cap, he wrote, factor-centric indexes outperformed by 2.1 percentage points yearly.
The rap on cap-weighted indexes is that the most sought-after stocks have a disproportionate effect on an index return. For a while now, the big tech stocks have sported the highest market value. Hence, when they run into trouble, as Facebook has of late, the entire index gets rocky.
Smart beta mutual funds debuted in 1981, from Dimensional Fund Advisors. The first smart beta ETFs came along in 2000, and they have held up pretty well. One such offering, iShares Russell 1000 Growth, targets the fastest-growing half of that Russell index. Over the past 15 years, the ETF is decently if not outrageously ahead of its benchmark, 9.62% to 9.0% annually.
Smart Beta Strengths
Smart beta is a way for investors who cannot afford hedge funds—or find another Peter Lynch among mutual funds—to take advantage of first-class analytics. To be sure, hedge funds are not miracle workers, and lately their average return has trailed behind that of the S&P 500. Like active mutual funds, though, they have their standouts that everyone wants to emulate.
One of the top-performing smart beta ETFs is Vanguard High Dividend Yield, which seeks out stocks with big payouts that are solidly grounded, and unlikely to be cut in turbulent times. Over 10 years, it has returned an average 15.83% annually, almost two percentage points more than its Morningstar category, large value. The logic of favoring steady dividend payers is that they furnish a nice bonus quarterly with their payouts, and that helps support the price. Furthermore, dividend-paying stocks usually are on the affordable side, which makes buying them less burdensome.
Low expenses are a key plus for smart beta. Because smart beta is mostly confined to ETFs, it tends to sport low fees, with an average of 0.46% per year, versus 0.59% for those not using smart beta.
The vast bulk of smart beta products are found in ETFs, which are easily tradable, tax-efficient, and cheap. As of year-end 2018, BlackRock’s iShares have the most assets under management in smart beta ($287 billion), followed by Vanguard ($172 billion). Invesco has the largest number of smart beta ETFs (130) and is third ranked by AUM ($65 billion).
And the trend is toward ever-lower fees. When Invesco bought the S&P 500 Equal Weight ETF, as part of a package from Guggenheim, the fund cut its fee to 0.20% from 0.33%. The best performers tend to have very low fees. Example: Vanguard High Dividend Yield charges just 0.06%.
Smart Beta Weaknesses
Cyclicality can be as unfriendly to smart beta as it is to other investing systems, as Morningstar’s Johnson said. Small-caps and value have not been barn-burners lately. Ditto international stocks. And no amount of clever factor usage can offset such downbeat trends.
Those situations haven’t pleased the San Francisco Employees’ Retirement System. SFERS just has axed two smart beta funds from DFA for underperformance: Its small-cap US value strategy (-6.6% for the 12 months through January 31, versus -4.6% for the Russell 2000) and its international small-cap portfolio (-17.1% for the same period, versus -15.1% for the benchmark). The two funds also trailed over three and five years.
Then there are simply bad use of factors. That’s the beef of Michael Hunstad, head of quantitative strategies a Northern Trust Asset Management. If a smart beta manager over-weights small stocks, for example, the fund may end up “with some illiquid names,” warned Hunstad.
And an emphasis on low-volatility, he noted, “may give you junky stocks.” Smart beta ETFs that fail to adequately assess the fundamentals of their stock picks are asking for trouble.
Simply screening for the 50 cheapest stocks in the S&P 500, using price/book ratios, doesn’t weed out the clunkers. And that multiple may be useless for tech stocks, which have hefty intangible assets. Searching for cheap stocks inevitably turns up utilities—and a good manager would know that rising interest rates are poison for them, something that a P/B screen can’t detect.
Moreover, some smart beta funds suffer from over-diversification. In Hunstad’s view, “as you increase the number of equity managers in a portfolio, you diversify away active risk.” Plus, he added, you glom on more fees. His company believes that correct use of factors can outdistance benchmarks without taking on undue risk.
Beyond those concerns lies the bald fact that beating a cap-weighted benchmark is all too often hard to bring off. Look at the Vanguard Dividend Appreciation ETF, which is the biggest dividend-oriented smart beta product. It has several quality-specific rules, like requiring 10 consecutive years of dividend increases and demonstrable profitability, to sift out high-yielding names that can’t keep lofty payouts going.
As of last week, the ETF has averaged 14.9% over 10 years. Not bad. Meanwhile, the S&P 500 was ahead with 16.4%. Yes, not all of the conventional index’s members pay dividends, but 420 of them do.
The bottom line is that smart beta is hardly leaving cap-weighted in the dirt.
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