Listen, I’m going to start with an inflammatory assertion, because that’s something I’m prone to doing and because “it gets the people goin’!”
Here’s my inflammatory contention: “smart beta” is bullshit.
And to the extent it started out some years ago as a right-of-center concept on a hypothetical continuum where the left is labeled “great idea” and the right is labeled “patently egregious bullshit”, smart beta ca. 2018 can properly be labeled “far-right”.
There’s so much wrong with the smart beta industry that it’s difficult to know where to start and to be sure, people who write under their actual, real-people names (so, not me) have written exhaustive critiques, many of which you can find with a simple Google search. If you’re looking for “credible” analysis from “very serious” people with LinkedIn profiles, just “type it in, Google’s ya’ friend brah” (to quote Jay-Z).
But you’re here for the jokes and the sarcasm, so that’s what I’m going to give you, sprinkled with a little analysis for good measure.
Unfortunately, this industry has mushroomed, with AUM in smart-beta products having tripled in five years to some $600 billion last year from under $200 billion in 2012.
The overriding issue here is that conceptually speaking, it’s not all that easy to nail down exactly “what smart beta funds is and what they does” (to adapt Thornton’s humorous regulations headline from earlier this year).
Proponents of these funds will tell you that’s nonsense – that I’m either ignorant or if not, then I’m being deliberately obtuse. Here, let BlackRock “explain” it to you via the simplest of simple sales pitches they give to investors on their website:
Factors – well known, well documented, well understood investment characteristics – are present in all portfolios. Factors are not new.
What is new is the way we access these investment ideas, such as through smart beta exchange traded funds. Smart beta ETFs capture the power of factors, delivering them in a cost and tax efficient structure, revolutionizing the way investors access these historically rewarded investment ideas.
Got that? Factor-based investing isn’t new (by definition, because you know, if you wanted to, you could call an investment in the broad S&P 500 a “factor-based” strategy), but harnessing its “power” by packaging it in ETFs represents a veritable “revolution”.
Ok, let’s go a little further, here’s more from BlackRock:
Smart beta can be used to improve risk-adjusted returns while retaining the transparency and efficiency of passive investing.
Smart beta can be incorporated as a low-cost substitute for some lower-risk active strategies, retaining the potential for active returns while increasing transparency and lowering costs.
See, now this has already taken a turn for the absurd or at least for the ambiguous. How exactly is zeroing in on these factors a “passive” strategy? Past a certain point, you’re just picking stocks. That is, the more narrowly defined the factor, the more inherently non-passive it is. That, in turn, raises the following obvious question, posed last year by Howard Marks:
Passive funds that emphasize stocks reflecting specific factors are called “smart-beta funds,” but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days?
And then what happens when market forces end up making certain stocks synonymous with multiple factors? Like, for instance, what happens when “momentum” becomes synonymous with “growth” or when an ongoing rally in stocks like the FAAMG constituents makes them synonymous with “low vol.”?
Well, I’ll tell you what happens. What happens is that you end up with factor crowding. Recall this from an infamous Goldman note released last summer:
While not exactly a Fields Medal worthy observation, we note that FAAMG is positively correlated with Growth and Momentum and this relationship has strengthened in recent months. The bigger anomaly, however, is that FAAMG is almost as highly correlated with Low Vol (as measured by standard deviation of 1Y daily price returns), which is not a characteristic typically associated with cyclically driven names.
Now consider that with the following from the same Howard Marks piece mentioned above:
Organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.
I’ll say it again: conceptually speaking, it’s not all that easy to nail down exactly “what smart beta funds is and what they does”.
Well that brings me neatly to a new piece out from Bloomberg profiling Vincent Deluard who was initially “a huge cheerleader for smart-beta ETFs,” but has since soured on the whole damn industry, because, as he puts it, “if everyone’s doing it, it’s not going to work anymore.”
But it’s not just that. He’s also angry with “facts” or, more to the point, how “facts” are used in the course of selling investors. To wit:
“The more I’ve seen this become mainstream, and the more I see how easy it is to fool people with facts — some long-term backtests, short-term stats — you realize quickly you can really prove anything,” Deluard said.
You sure as hell can, Vincent. And perhaps the most hilarious example of someone doing just that in the course of throwing a bit of good-natured shade on smart beta, was Bloomberg’s Dani Burger, who last year built her own theoretical factor fund based on an index comprised of companies that had “cat” in their name.
As it turns out, Dani’s “cat factor” strategy back-tested quite well, and by “quite well” I mean it returned 849,751%.
Not too shabby, right?!
The quant community was not particularly amused with that exercise and they’re probably even less amused with the above-mentioned Vincent, who built himself a “DUMB” factor made up of 200 names not included in five popular factor-based funds, which he rolled up into its own index called “SMART”. He did that the night before the U.S. election.
Well guess what? Through April, “DUMB” has beaten “SMART” by more than 2%.
There’s a ton of additional color in the Bloomberg piece, but the punchline is undoubtedly this:
Deluard says he remains bullish on the “DUMB “.