Adding Wisdom to Smart Beta Strategies
Smart Beta ETF’s have captured the imaginations of the investing public over the past five years, growing to more than 440 ETF’s and over $450 billion in assets, according to Morningstar. The growth in names and assets suggests that financial advisors and investors find some value in these strategies. The question that needs to be asked is, “By itself, is this a winning strategy?”
What is Smart Beta?
While traditional indexes consist of a list of securities weighted by overall size, some people have concluded that this weighting presents an advantage for large securities and a disadvantage for small securities. Many investors have concluded that this inequity must create exploitable inefficiencies within the market, bringing about the growth of Smart Beta. Smart Beta strategies involve researching and investing in a specific subset of the overall market that exhibits common attributes. The expectation of Smart Beta strategies is that those shared attributes will produce an investment return superior to the traditional weight-based index discussed above.
The concept of Smart Beta strategies is not new to the investment world. Professors Eugene Fama and Kenneth French of the University of Chicago Booth School of Business identified the predictive capacities of certain common factors exhibited within the companies that compose the public markets. They initially ranked companies according to three characteristics: company size, valuation, and price momentum.
Little has changed in the almost 25 years since Fama and French published their first paper on the topic; these three characteristics remain the primary drivers of most Smart Beta strategies. However, one change has been made: Quality was added as a factor to round out the offering.
Good idea run afoul?
Little disagreement exists over the theory that these factors demonstrate an ability to capture excess returns. As mentioned above, the most common explanation of the factors’ ability suggests that the success of traditional asset-weighted indexing has created exploitable inefficiencies.
Research into the returns associated with these factors has shown that their generated alpha is inconsistent over time. Ample evidence suggests any one of the factors could lead the market one year only to underperform swiftly the next. The level of volatility, much like the volatility shown in individual securities, calls into question the sustainability of the inefficiency that firms attempt to capture. The results, as shown over time, are excessive trading and poor timing, both of which lead to large costs and an inability to consistently capture the desired inefficiency.
The single factor return history presented by MSCI (Figure 1) shows the differences in return between Smart Beta strategies and the weight-based index. There are times when a particular strategy will differ so greatly from the index that one can celebrate the results of the bet made. For example, a focus on Momentum in 2011 would have produced a 4% positive absolute return — before fees and implementation costs — versus a loss of over 5% by the index.Volatile Alpha Generation
Approaching the strategy in a different situation, would the bet on Quality in 2008, which resulted in a loss of 38% versus a loss of almost 41% by the index, make you want to crack open a bottle of champagne?
Figure 1 demonstrates that the factors are fairly consistent over the 16 years presented: each factor detracts from performance about one third of the time. Each has outperformed the standard weight-based index. However, the time frame used can provide a false sense of confidence. In the initial historical view of the factors — the past 25 years —Quality demonstrated the best performance. However, in May of 2015, MSCI expanded the timeframe to include the past 40 years. The inclusion of 15 more years in the timeframe caused Quality to fall to the second worst performing factor. Moral of the story: timeframe matters.
The Need for Wisdom
In the world of investing, new “tricks” are frequently marketed as ways to cheat the system and outperform the index. Some may actually work, if one is able to remain consistent over time. However, all too often, the trick fails for a period of time, causing the investment industry to panic, believing their past success is inimitable. This fear appears to reflect the investing majority’s incomprehension of the fact that that these factors can be cyclical and coincide to patterns within the business cycle.
A deeper look into the periods of outperformance and underperformance and the corresponding Smart Beta index composition offers some insights and poses questions.
Is it a coincidence that Value experienced five years of material outperformance during the late stages of the housing and mortgage bubble, when the financial sector represented close to 25% of the value index?
Additionally, is it a coincidence that the Quality factor experienced its winning streak over the past 15 years during the late stages of the commodity cycle when the Energy, Industrial, and Material sectors averaged a third of the weight of the Quality index?
The one factor that appears to have a mind of its own is the Momentum factor. This is evident from the volatility in its holdings: Momentum-based sector weightings having the largest swings of all factors. The factor’s need to “recalibrate” each year to mimic the strong momentum experienced by securities may be the reason for its volatile excess return in the early phases of the new century, when markets were going through a period of reconstitution.
Smart Beta techniques open up a level of abstraction to the investing world, offering investors a more efficient method to capture outsized returns in areas of perceived inefficiency. While this may produce desired results over some time periods, the cyclicality of performance witnessed historically may make the capturing of alpha elusive. So this produces one question: Is the Smart Beta abstraction layer hiding the real inefficiency?
NBA Player Carl Landry Demonstrates the Value of Persistence in Life and Work
Written by: Jon Sabes
When you meet Carl Landry, stand-out college basketball player and nine-year NBA player, you imagine that becoming a professional basketball star was a straight forward run for the 6-foot-nine-inch power forward.
However, when you go deeper into Carl’s background, becoming a NBA professional was less than certain and little came easily to the 33-year-old from Milwaukee:
- He was cut from his high school team as a freshman and averaged less than ten points a game when he did play as a senior.
- He started his college career not at Purdue, but a junior college where it was not clear he would play.
- When he finally got to Purdue, he tore his ACL in his knee his first year and reinjured it the next year.
- While his family held a party for him the night of the NBA draft, he slept in the Philadelphia airport after missing a flight following a workout for the 76ers.
- In the NBA playoffs, Carl had a tooth knocked out, but came back in the same game to make a game-winning blocked shot as the Rockets beat the Utah Jazz 94-92.
Landry, who I interviewed on my podcast, Innovating Life with Jon Sabes (www.jonsabes.com), is a remarkable example of the value of “persistence.” In a time where technology creates the image that anything is possible at the touch of a button, persistence is an under-appreciated trait. When I spoke with Carl, I clearly saw someone for whom success has only come through a force of will that made him a NBA player, but it also made him a better player every year he played. That’s the kind of personality that has produced greatness in business as well as sports.
Carl was, in fact, drafted that night he spent in the airport. The Seattle Supersonics chose him as the 31st overall pick and then traded him to the Houston Rockets where he rode the bench for much of the first half of the season. When All-Star teammate Yao Ming was injured, he stepped in and played a key role in the Rockets astonishing 22-game winning streak (the third longest streak in NBA history). And, that season, after sitting on the bench for 33 of the first 36 games, he was named to the All-Rookie second team.
Carl was the first in his family to go to college. “I told myself that this was my ticket out, so I did everything I possibly could to be the best person in school and also on the court,” he said.
His family life in Milwaukee showed him what he didn’t want to do. “Just being honest with you, seeing some my cousins, peers, they went to work for jobs paying six, seven dollars an hour or they didn’t go to work at all and then living off welfare. I didn’t want that.”
When he was first injured, he had to contemplate the end of a career before it even got started. “When you have an ACL tear, it’s over…no more basketball,” he told me. “I said, God, give me health again and I’ll do everything I can to leave it all out on the line and be a successful individual.”
On my podcast, Carl pointed out another interesting lesson he learned in the NBA: Not doing things just to fit in.
“Fitting in was easy,” he said. “Doing everything that everybody else does was easy. If I stood out in some type of way, I’m going to have different results. I’m going to have stand-out results.”
That’s called the “Law of Contrast” and it produces that exact effect of changing the outcomes that everyone else is experiencing. Carl is smart, he recognized that differences make a difference, and doing whatever it takes is what is required to make real, meaningful differences.
Every off-season for the last 11 years, he has run a camp for kids in Milwaukee where he tells youth his story of hard work and persistence. “I always tell the kids to apply themselves and always be persistent,” he said. “If you dream, apply yourself and be persistent. With hard work, man, the sky’s the limit.”
When Carl says the sky’s the limit he means it. He is smart to recognize that it’s important to dream big, because if we don’t – we may be selling ourselves short. “You have to dream bigger than your mind could ever imagine,” he said. “I wanted a nice house. I wanted a nice car. I said, and I got all of that. So, what do I do, do I stop now? Maybe I didn’t dream big enough.” That’s a big statement coming from a kid who grew up to be the first in his family to graduate college and go on to be not only a top NBA basketball start, but a good businessman, father and someone who gives back to the community.
I’m convinced that in whatever he takes on as a basketball player or in his post-hoops career, Carl Landry is not going to stop getting better at whatever he does, and in the process of doing so, make the world a better place.
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