Under What Circumstances Will 'Smart Beta' Work?

by David Merkel, Aleph Blog

I’m not an advocate for smart beta.  There are several reasons for that:

• I don’t pay attention to beta in the stocks that I buy; it is not stable.
• The ability to choose the right brand of enhanced indexing in the short-run is difficult to easily achieve.
• I’m a value investor, a bottom-up stock picker that doesn’t care much about what the index does in the short-run.  I aim for safety, and cheapness.

But today I read an interesting piece called Slugging It Out in the Equity Arena.  It talks about an issue I have been writing about for a long time — the difference between what a buy-and-hold investor receives and what the average investor receives.  The average investor chases performance, and loses 2%+ per year in total returns as a result.  As the market relative to the index is a zero-sum game, who wins then?

The authors argue smart beta wins. They say:

To us, the smart beta moniker refers to rules-based investment strategies that use non-price-related weighting methods to construct and maintain a portfolio of stocks.¹ The research literature shows that smart beta strategies earn long-term returns around 2% higher than market capitalization-weighted indices. Moreover, smart beta strategies do not require any insight into the weighting mechanism. One can build a smart beta strategy with any stock ranking methodology that is not related to prices, from a strategy as naïve and transaction-intensive as equal weighting to a more efficient approach such as weighting on the basis of fundamental economic scale. For example, a low volatility portfolio and its inverse, a high volatility portfolio, both outperform the market by roughly 2%—as long as they are systematically rebalanced.²  It is not the weighting method but the rebalancing operation that creates most of smart beta’s excess return. Acting in a countercyclical or contrarian fashion, smart beta strategies buy stocks that have fallen in price and sell stocks that have risen.

When I read that, I said to myself, “That is a more intense version of my portfolio rule seven:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

I learned this rule from three good managers — one growth, one core, one value.  They were all fairly rigorous in their quantitative analyses, but they all agreed, a 20% filter on target weight added ~2%/year to performance on average.  But unlike the current “smart beta” discussion, I have been using this idea for the last 15-20 years.

The mostly equal-weighting also induces a smallcap and value tilt, which is an additional aid to performance.  Since I concentrate by industry, the 30-40 stocks requirement does not lead to over-diversification, as a great deal of my returns comes from choosing the right industries.

In one sense, portfolio rule seven is an acknowledgement of mental limitations, and is an exercise in humility.  So things have been great?  They will eventually not be so.  As prices go up, so does fundamental risk.  Take a little off the table.  Raise a bit of cash.

Things have been bad?  Look at the fundamentals.  How badly have they deteriorated? This can take three paths:

a) Fundamentals have deteriorated badly, or I made an initial error in judgment.  I would not own it now, even at the current price there are much better stocks to be owned.  Sell the position.

b) Fundamentals are the same, a little better, or haven’t deteriorated much.  Rebalance to target weight.

c) Fundamentals are better and people are just running scared from a class of companies — not only rebalance, but make it a double-weight.  I only do this in crises, for high-quality misunderstood companies like RGA and NWLI in the last financial crisis.  Some of that is my insurance knowledge, but I have done it with companies in other industries.

For fundamental investors, who think like businessmen, there is value in resisting trends.  Having an orderly way to do it is wise.  Don’t slavishly follow me, but ask whether this fits your management style.  This fits me, and my full set of rules.  Modify it as you need, it is not as if there is one optimal answer.

I’ll close with an excerpt from the first article that I cited, which was its summary:

KEY POINTS

1.     Smart beta strategies are countercyclical, periodically rebalancing out of winning stocks and into losers. They may underperform for extended periods but they ultimately tend to prevail.

2.     Investors’ procyclical behavior, selling recent losers and buying recent winners, pays for the estimated 2% per year in long-term value added by smart beta strategies.

3.     Smart beta investing can be reasonably expected to have an edge as long as investors persist in following trends and chasing performance.

Are you willing to take the long-term view, meaning more than 3 years?  These ideas will work.  Focus on longer-term value, and do your analytical work.  And if you outsource your investing, be willing to allocate more to stocks during bad times.  To avoid really ugly scenarios, wait until the 200-day moving average has broken to the upside, of look at the 13Fs of value managers.

Do that and prosper.  Resisting trends intelligently can make money.

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