Bearings April 2015

A Comment on Smart Beta

Smart beta is a "new" term for investments Pilotage Private Wealth has been allocating to for years, namely investing in securities based on their Size (large cap vs. small cap), Value (low price to book vs. high price to book), or another metric/factor that is not market capitalization driven. Currently, there are over 600 different factors which academics have used to decompose a security’s returns1.

In reality, most of these 600 ‘factors’ which seek to generate returns above the market are impossible to replicate in the real world after accounting for taxes, trading costs and slippage 2. After further refinement, there are really only a handful of premia which accomplish the following feats; observable over long periods of time, statistically significant, exhibited globally, and have a positive expected return after trading/slippage costs. The premia which pass the test are momentum, value, low volatility and size 3. While a bit technical, the table overleaf from Research Affiliates shows various factors and their level of statistical significance.

The real question is why do these strategies provide persistent (albeit not consistent) additional return? To quote John West and Ryan Larson of Research Affiliates, "…investors taking the other side of smart beta trades would be those who buy stocks after they rise in price and sell after they fall. They are trend-following, performance-chasing investors; we consider them "procyclical" investors. Smart beta strategies are countercyclical, periodically rebalancing out of what has been working and into less favored stocks. Why do investors persist in costly procyclical behavior? The short answer is that they prefer to do what is comfortable. Buying winners and avoiding losers is a chronic pattern of financial behavior"4.

The other point worth noting is that all of this excess return comes with a cost; there are rarely (if ever) any free lunches in investing. With the premia such as momentum, value and size, that additional cost comes in the form of the higher volatility that these strategies exhibit. With premia such as low volatility, the cost is typically upside performance. Perhaps this is changing the goal posts a bit, but for Pilotage Private Wealth, having higher levels of risk-adjusted return are paramount. When deciding between two investments we would allocate to the investment with a higher expected return per unit of risk vs. the investment with the highest expected total return, all things being equal.

Where we slightly differ in opinion from the DFA research paper in that we believe how returns are generated is just as important as the total realized return. That is, if a client must endure a 50% drawdown in a strategy to hit a certain return target, then it is no strategy at all as many would not have the "stomach" to endure such gut-wrenching volatility. The critical step is devising methods to allocate to these strategies that focus on risk-adjusted returns and not only maximum return.

Investing in smart beta strategies is no panacea. As mentioned above, investing counter-cyclically does produce higher returns over time, but at the cost of higher-realized volatility. We all seek the highest returns possible on our capital, though the risk taken to achieve these returns must be analyzed as well. The portfolio management team at Pilotage Private Wealth remains steadfast in our pursuit to create and implement allocation methods which harness the return potential of style premia, while being mindful of the potential risks.

Click here for the detailed analysis: Pilotage Article: Smart Beta

1 Levi, Yaron, and Ivo Welch. 2014. "Long Term Capital Budgeting." Working Paper (March 29). cfm?abstract_id=2327807.


3 Hsu, Jason and Kalesnik, Vitali, 2014. "Finding Smart Beta in the Factor Zoo". Insights/Fundamentals/Pages/223_Finding_Smart_Beta_in_the_ Factor_Zoo.aspx.

4 West, John and Larson, Ryan, 2014. "Slugging It Out in the Equity Arena". Fundamentals/Pages/Slugging-It-Out-in-the-Equity-Arena.aspx.