There is an article on Moneyweb this morning called “Smart Beta: This Is What You Need To Know“. It’s quite dense, but I think that this is the important part:
Many overseas investors take investing quite seriously and do a lot of their own research online and through other platforms. In South Africa, investors often prefer the guidance of an advisor that could be held accountable if things go wrong.
Which is to say: we shouldn’t worry about Smart Beta funds, because no financial advisor in their right mind is going to sell you a fund that moves against the market, for fear of being “held accountable”.
To illustrate: in all the market bloodshed since the beginning of the year, my inbox has been flooded with cautionary emails from South African wealth managers (I apparently sign up for their newsletters when I want to look at their fund factsheets). It’s all “don’t worry about market downturns – they happen from time to time” and “no one can accurately predict the market 100% of the time” and “this just creates buying opportunities”. It seems that they’re being inundated with accountability. And for that, they have my sympathies. Can you imagine?
“I pay you people all those fees, and you are LOSING MY MONEY. What am I paying you for?”
As though a 1.5% Assets-under-Management fee entitles one to never lose money (if anyone could guarantee that, you can best believe that those fees would be higher).
But to go back to the Smart Beta issue, I thought I would revisit some older content from early last year.
To start, here is some advertising with buzzwords:
Investopedia has this un-exciting definition:
DEFINITION OF ‘SMART BETA’
Investment strategies that emphasize the use of alternative weighting schemes to traditional market capitalization based indices. Smart beta emphasizes weighting schemes based on fundamentals or market inefficiencies. The increased popularity of smart beta is linked to a desire for portfolio risk management rather than only investment return.
And what they mean by that is: “a active-passive investment invented by an active manager, which sounds dangerous, and almost certainly is, most of the time.”
So let me give you an insight into the thought process in the mind of an active fund manager*:
*Just to remind you – the world is split into two kinds of fund. Passive funds are not managed by a human fund manager – they’ve got a robot that’s been programmed to make the fund investments match those of an index, or something similar. Active funds are managed by a human fund manager, who is hopefully smarter than all the other active fund managers, and also hopefully smarter than the dumb money in passive funds.
- Look at this passive investment fund.
- There’s a lot of money invested in this passive investment fund.
- Look at all those fees that I’m not earning!
- I wonder if there’s something that I could do to change that.
- Well, there are some problems with these passive investment strategies…
- For one thing, passive index tracker funds have a tendency to buy up shares that are overvalued by the market, and sell off shares that are undervalued by the market.
- How do I know that some shares are overvalued and some are undervalued?
- Well, mostly common sense and gut feel, if I’m honest…
- But if I were justifying the decision to my investors, I’d use momentum indicators, dividend yields, market-to-book value ratios…
- Hey – those factors sound like things that I could write into an algorithm!
- I’ll take a passive index-tracker algorithm, and get it to weight things differently depending on momentum indicators, dividend yields, and market-to-book ratios!
- That’s not just earning the market beta.
- That’s smart beta.
- Also: less work for me, more money for me.
- *calls marketing department*
As I see it, market agents have realised that the passive index-tracker funds have the potential to create long-standing market inefficiencies, and this is their attempt to address it.
For example: if a stock is unliked by the market, then the passive index-tracker funds will all underweight it (ie. the stock price is damaged by the active investors, and then the passive investors double up the damaging). At this point, you’ll get active investors starting to say things like “this stock is undervalued – we should buy it” – but their renewed enthusiasm has to take on all the dislike that has been entrenched by the passive index-tracker funds – who are not really market agents so much as they are market replicators with a bit of a feedback loop. Really, what I’m saying is: the price-adjustment process is probably sluggish.
So what is actually needed here are some contrarian passive funds that will counteract the über-conformist passive fund majority (you don’t get more conformist than an index-tracker fund, I’m afraid): hence the growing interest in “smart beta” contrarian passive funds.
And in principle: I’m a fan.
In practice, however, I have some concerns:
- When dealing with a standard passive index-tracker fund, you don’t really need to understand the algorithm or the market.
- And in any case, standard passive index funds are relatively easy to understand – “You’ll do as well as the market does; and it will be cheaper than doing anything else. The rest is mostly detail that you don’t need to trouble yourself with.”
- But with smart beta funds, you don’t really know what you’re getting: and unfortunately, the success of the fund is only as successful as the algorithm that it’s programmed with.
- That is: an ex-active manager could set up a smart-beta fund, and decide “This will follow the market, except where the market-to-book ratio is above 6 or below 1, in which case, the weighting will be underweight by 40% if above 6, or underweight by 40% if below 1, unless this is a resource share, in which case the weighting will be underweight by 100% if above 4, underweight by 80% if above 3 by less than 4, and overweight by 60% if less than 1…”
- And unless you’re the manager that decided on the rules, or a finance nerd, you’re not really going to know what the smart beta fund is doing, or what the completely arbitrary weighting assumptions mean (phrases like “underweight by 40%” are bizarre).
- The thing is: the market is mostly comprised of people and their algorithms – very few of which are rational investors with long-term investment horizons.
- So codifying responses to the randomness of the markets seems like dangerous territory to me.
- As in: you can have some basic principles for dealing with the market, but the minute you do too much of it, you’re asking for trouble.
- Also: feedback loops. Which make the whole exercise look like chaos theory.
So here are my take-home thoughts:
- Smart beta funds are probably a good idea.
- But for my money, the simpler the smart beta fund, the better.
- If you’re thinking of heading down this route, get a financial advisor.
- Because for this kind of thing, everybody could do with some advice.
- If you can find a financial advisor who will take on the risk of advising you to buy a smart beta fund.
For more, here’s a bloomberg article that’s quite cool: “Smart-Beta ETFs Attract Billions With Critics Blaming Dumb Money.”
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.