Would Benjamin Graham Invest in Smart Beta?

Smart beta and Benjamin Graham’s value investing may be cut from the same cloth, according to Research Affiliates.

Charles Aram, the firm’s head of EMEA, argued that value investing’s rules-based approach to security selection “supported by a firm’s financial strength, earnings, dividends, and assets,” can also be found in the heart of fundamental index strategies.

“The effective result is to sell securities whose price, and therefore capitalization, has increased over the year relative to its metrics, and to buy those securities that have had the opposite experience,” he wrote.

These qualities could be most attractive to those Graham identified as “defensive investors,” or those aiming to avoid serious mistakes and losses while seeking “freedom from effort, annoyance, and the need for making frequent decisions.”

“The effective result is to sell securities whose price, and therefore capitalization, has increased over the year relative to its metrics, and to buy those securities that have had the opposite experience.”In addition to smart beta’s quantitative characteristics, its annual reweighting and rebalancing allows for “dynamic exposure to value and size factors,” Aram said. 

Fundamental indexing strategies could extract excess returns from ramping up exposures to factors when they’re out of favor, and lowering those that may be overvalued. 

Research Affiliates’ data supported these theses and found the fundamentals-weighted portfolios had a Sharpe ratio of 0.47 over the last 50 years, compared to 0.33 from cap-weighted portfolios.

However, Aram wrote that holding a contrarian position, whether it be value investing or smart beta strategies, could be difficult for many investors.

“These disheartened or fearful investors—possibly struggling with career risk or myopic loss aversion, or ultimately, just from the human condition—are often the other side of the trade,” he said. “Courage and conviction are often casualties of an ‘uncooperative’ market.”

The same “human condition” can be an investor’s worst enemy, Aram warned. Selling an underperforming security can hurt an investor’s total return, particularly if high fees are involved.

Aram also suggested investors not get discouraged by fundamental index strategies’ recent underperformance. 

Heeding to Graham’s advice, investors should add to positions on the downside, as they can “lead to higher returns at later points in the economic and market cycles.”

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