Is Smart Beta Smart?
Research Roundtable Publication
In a recent post, our friend and previous contributor, Joachim Klement, returned to a topic he’s covered before, asking this question:
Why do Smart Beta ETFs perform so poorly?
Smart Beta is the marketing term for the popular investing style called factor investing, which some asset managers describe like this:
“An investment approach that involves targeting specific drivers of return across asset classes [which]…
Allows us a laser-like focus on the sources of return in a portfolio [that can] add diversification by potentially allowing us to access new sources of return.”
Sounds great, right?
Well…
As we discussed on a previous post with Klement, in the investment world “there is always a ‘but’ somewhere.”
Systematic or so-called smart investment factors perform worse after they have been revealed, which fits into this all too common four stage cycle of investment strategies:
- Research identifies attributes that have driven outperformance.
- Managers launch new products or tilt existing strategies based on the attributes or factors.
- Assets grow rapidly and more researchers work to exploit the factors.
- The products based on the factors underperform as they are no longer unique.
Related to this, Klement points to a new paper from researchers at the University of Hong Kong and University of Washington who found that Smart Beta underperformance can also be driven by what they call “data overexploitation.”
What does this mean?
In more simple terms it seems that some materials that tout Smart Beta are cherry-picking time periods and other factors, which can make back tested returns look better than what is possible going forward, especially after factoring in real world realities such as fees, trading costs, and taxes.
We are sure that others have more artfully explained the ins and outs of all of this. The next time you receive a “smart” pitch, however, it might be good to ask a few more questions and keep in mind this punch line from the researchers’ paper titled The Smart Beta Mirage.
“Smart Beta indexes trail the aggregate market when they become accessible to investors”
And…
“The majority of Smart Beta ETFs do not add value to investors in terms of returns.”
Enough said.
Once you factor in all the factors, Smart Beta strategies often don’t seem that smart.
Related Reading:
The Smart Beat Mirage – Shiyang Huang, Yang Song and Hong Xiang
The Future of Factor Investing – Joachim Klement, CFA
Are Selectors Good At Selecting – Elisabetta Basilico, Phd, CFA
Don’t Put Yourself in a Corner – Joachim Klement, CFA and Preston McSwain
How to Actively Add Value – Joachim Klement, CFA and Preston McSwain
The Road Less Traveled – Simple Alternatives 
Are Most Investment Managers One Hit Wonders? 
The Certain Drag on Performance – Taxes