Getting Smart About So-Called Smart Beta

Factor Review

The concept of value should be familiar to most investors. It describes the phenomenon where stocks that are trading at low valuations tend to outperform their more expensive counterparts over the long term. Some researchers argue that this return premium is compensation for risk. Value stocks tend to have dim growth prospects, lower-than-average profitability, and have often been struggling for years. Yet, investors may penalize these companies too much by extrapolating recent performance too far into the future. This might explain why value stocks have generated better risk-adjusted returns than the market over the long run. Dividend income and fundamental index strategies harness a flavor of the value effect.

Momentum is the tendency for recent performance to persist. Stocks that have recently had the best recent relative performance often continue to outperform over the short term, while those with poor relative performance continue to underperform. Behavioral finance researchers argue that this effect arises because investors tend to underreact to new information and pile onto a trade once a trend is established. While it is difficult to articulate a conventional risk-based explanation for momentum, this strategy does not work well when volatility spikes. It experienced its worst performance during the 2008 financial crisis and the Great Depression.

Stocks with low volatility have historically offered better risk-adjusted performance than their more volatile counterparts. This effect may occur because many institutional investors face leverage constraints but are compensated based on their performance relative to a benchmark. In order to boost their relative performance, these managers may overweight high beta stocks, pushing their prices above fair value. Investors may also overpay for volatile stocks that offer a small chance of a big payoff--much as they might purchase a lottery ticket.

Quality is an opaque term, but it generally represents the effect where stocks of companies with high and stable profits have historically outperformed those with lower and less consistent profits. At first blush, that may seem contradictory to the value effect. Quality stocks tend to command higher valuations than their lower quality counterparts, but it appears that the market has historically underestimated the long-term persistence of quality stocks’ profits, which durable competitive advantages can protect. Dividend growth funds essentially capitalize on this quality effect.

That’s Great, But…

Even though these strategies have worked well over the long term, they may underperform for years. But even a long investment horizon may not be enough. After all, a strong long-run performance record is no guarantee that a strategy will continue to work in the future. A profitable strategy is more likely to persist when the underlying effect has an economically sound risk-based explanation, is difficult to arbitrage, or is created by institutional frictions. It’s not obvious that quality possesses any of these characteristics. Quality stocks tend to outperform during bad times, which makes quality a relatively low risk strategy that should be easy to arbitrage. Nor are there any apparent institutional frictions that might cause investors to underprice quality stocks. If anything, it might be reasonable to expect a bias toward these stocks.

The observed quality premium may simply result from behavioral biases. Behavioral biases will not likely self-correct overnight. As long as there is a human element in the equation, fear and greed will still sway the market. However, after a profitable strategy like quality has been discovered, and it is not merely compensating for risk, it may lose its effectiveness as more investors exploit it. But quality stocks will still likely outperform during periods of economic distress. Consequently, the strategy may still have a viable role from a diversification prospective.

Barriers to arbitrage and institutional frictions may have protected momentum in the past, but those barriers are coming down. Historically, most large money managers relied on fundamental analysis. The idea of buying stocks that went up and selling those that went down was contradictory to the conventional wisdom. Consequently, it was not a very saleable strategy. However, as momentum has gained wider acceptance in the academic community, more hedge funds have moved to exploit it. The high turnover necessary to harness momentum can create high transaction costs, making it difficult to arbitrage. But there are now more momentum funds around the world, but limited in Asia, available that help rein in transaction costs. While corrective arbitrage probably won’t completely eliminate momentum in the near term, the strategy may become less effective as it becomes more popular. Fortunately, a lot of investors still haven’t bought into it.

The success of the value and low volatility strategies is more likely to persist. Value stocks have a plausible risk story. These stocks often struggle during weak economic environments. Because investors demand compensation for bearing risk that cannot be diversified away, value stocks may continue to offer outperform. But even if the value effect is simply the result of behavioral biases, it is difficult to arbitrage because it can take years to payoff. These stocks may also carry a stigma that can leave them undervalued, particularly because there is often little to like about them. There’s good reason for caution. Value traps, stocks that look cheap but become cheaper, can destroy wealth.

Although the low volatility effect may be easy to exploit, the institutional frictions behind it may allow it to persist. As long as active managers face leverage constraints and are compensated based on their performance relative to a benchmark they will have an incentive to overweight risky stocks to boost performance (and their paychecks). Consequently, low volatility stocks may remain overlooked and mispriced.

Combining Strategies

It may be possible to improve performance by combining some of these strategies. For example, combining value with quality may help investors avoid both value traps and overpaying for quality, if and when the market catches on.  For instances, a fund could target stocks that have attractive dividend yields, cash flow to debt ratios, returns on equity, and dividend growth. Putting value and momentum together is also a promising combination. Many value strategies inherently bet against momentum, which can hurt returns.  

Keep It Simple

Fund companies often use complexity to justify high fees, even if it generates only mediocre results. Complexity may also be indicative of data mining, which can produce a strategy that may not work out of sample. It is a good practice to discount back-test results, and demand an intuitive, common-sense explanation of the strategy you are evaluating. As a rule of thumb, if it takes longer than a minute to explain a strategy fund to a friend, it is probably not worth pursuing. Transparency and low fees are essential. Because passive investment strategies do not require human intervention, they should charge significantly less than actively managed alternatives.

Alex Bryan is a fund analyst with Morningstar.