Active Management 2.0
The popularity of strategic-beta strategies risks dooming these funds to underperformance.
This analyst blog is part of our coverage of the 2016 Morningstar Investment Conference.
Traditional active managers have found conventional market-cap weighted benchmarks like the S&P 500 Index formidable foes. A new wave of so-called "strategic-beta" or "smart-beta" strategies promise better outcomes. These funds track rules-based indexes that overweight stocks based on investment factors such as valuation, size, momentum, profitability, and volatility, which academic research has tied to superior risk-adjusted returns. Whether these market inefficiencies will persist--and whether investor can take advantage of them--were the central questions considered at a Morningstar Investment Conference panel on strategic beta.
Although terms like strategic beta and smart beta are new, the principles behind them are not. Marlena Lee, the vice president of research for Dimensional Fund Advisors (DFA), noted her firm has been building value- and small-cap leaning portfolios for nearly 30 years. Co-panelist Joel Dickson, Vanguard's head of research and development, pointed out quantitative investors have long used valuation- and momentum-based screens. In fact, Dickson suggested the fund industry dreamed up "smart beta" in an effort to rebrand quant-based strategies after many turned in poor showings in 2007 and 2008.
Investors have certainly cottoned to strategic beta, with factor-based ETF assets rising from roughly $150 billion to $450 billion over the past five years. Such popularity risks dooming these funds to underperformance. After all, it's usually not long before market inefficiencies disappear. But each panelist expressed confidence the factors commonly underlying most strategic-beta strategies will persist despite their popularity. Value and small-cap stocks will continue to outperform because they entail more risk, said co-panelist Rob Nestor, a BlackRock managing director and head of iShares' smart-beta business. Real-world constraints, such as investors' unwillingness or inability to use leverage, bode well for low-volatility stocks, he said. Without tools like leverage to juice returns, managers turn to higher-volatility stocks as an alternative, systematically mispricing lower-volatility names.
Of course, even if these market inefficiencies survive, it doesn't mean investors will be able to successfully exploit them. The theory behind factor-based strategies often depends on performance back-tests of long/short portfolios (long stocks with low valuations and short stocks with high valuations, for example). Because most fund managers can't or won't short stocks, Dickson argued investors are unlikely to earn the same premiums identified in the academic research. Long-only portfolios by definition are more market-sensitive than long/short portfolios, weakening their exposure to other factors. What's more, long-only rules-based indexes often underperform their back-tested results when they go live.
Even well-executed strategic-beta approaches can be misused by investors--misbehavior often abetted by asset managers who launch products at inopportune times. The launch, and popularity, of value-oriented ETFs following value stocks' big run was a case in point, said Dickson.
The best defense against mistiming single market factors, BlackRock's Nestor argued, are multifactor strategies. As the name implies, these ETFs screen on an array of factors which don't behave in sync with one another. Value zigs when momentum zags, for example.
The panelists disagreed somewhat on the role strategic beta ETFs play in a portfolio. DFA's Lee said her firm prefers to manage volatility through asset allocation rather than with low-volatility strategies. More bond-heavy portfolios offer smoother return trajectories, but Dickson countered Lee's argument by pointing out this means investors are trading equity risk for bond risk. Volatility-sensitive investors, such as those nearing or in retirement, may find low-volatility funds a good fit with their risk tolerance.