by Josh Rubin, Thornburg Investment Management
“Smart Beta” ETFs and their low-volatility ETF progeny may deliver a lower beta against their relevant benchmarks, but they’re not immune to bouts of volatility, and their returns frequently come up short.
How smart are “smart beta” products? As factor-based investing is the latest fashion in the allocation trend to passive exchange traded funds, the performance of the most popular among smart beta instruments—the low volatility ETFs—is worth a look. Do they deliver?
Context is helpful in understanding both their longer- and shorter-term performance, as well their volatility against stock market benchmarks. In essence, passive investing is a bet on general economic progress and a belief that it’s too hard to sort out winners from losers. So future economic growth broadly lifting all corporate boats creates the return.
Smart beta tries to take the bet a step further by using historical relationships in asset price movements to predict the direction of future price movements. That, of course, runs counter to the most frequently used compliance disclaimer in investment advertising: “past performance is no guarantee of future results.” Nonetheless, smart-beta employs backward-looking characteristics in a bid to differentiate the return—effectively, a stock was good before, so it will be good in the future.
In the case of “low vol” ETFs, historically they have indeed delivered a beta, a measure of market-related risk, 20% to 25% lower than the relevant indices. But, this hasn’t come with differentiated total returns in recent measurement periods.
In the U.S., the PowerShares S&P 500 Low Volatility Portfolio (SPLV) ETF and the iShares Edge MSCI Min Vol USA (USMV) ETF, both lagged the S&P 500 Index and the MSCI USA Index by roughly 30 to 50 basis points over the first six months of the year, and by nearly 1,000 basis points over the trailing one-year period.
Although both beat the two U.S. indices in the three-year period, they badly lagged in the five-year timeframe. Underperformance in overseas developed, emerging and global segments is also mostly evident in the same measurement periods, again excepting the three-year timeframe outside of emerging markets. The three-year timeframe coincides with a period of trending markets and economic stability as central banks committed to mitigating economic and market volatility and risk.
To be sure, lower beta is generally indicative of lower share price volatility. But there have also been short periods when low vol ETFs have had higher volatility than the overall market, failing at their core mandate.
The key flaw with smart-beta products is that they are backward-looking, while markets are dynamic, driven by changes in consumer tastes, corporate strategy, and government policy—let alone the underlying forces of creative destruction. Imagine riding in a taxi with a driver insisting that he didn’t need the windshield, side windows or dashboard because everything important was visible in the rearview mirrors. Active managers, by contrast, utilize manifold views—including the rearview—and a multiplicity of instruments designed for forward-looking risk management in pursuit of differentiated upside capture.
In effect, smart beta has delivered inconsistent performance across market environments because it is backward-looking with no predictive analysis built into its design. So downside protection among low vol ETFs has been mixed in market selloffs. On the flip side, they have underperformed in up-trend markets this decade because they seek to buy historical performance, but are always late to the game: they take too long to capture market rotations in their calculations and periodic rebalancing. They didn’t capture the Trump-bump or the European economic upswing rotations. As we move into a period where central banks step back from their recent efforts to provide market stability and to encourage risk taking, can low vol ETFs capture the market’s future dynamism just by looking backward?
At a micro-level, low vol algorithms also don’t capture corporate turnaround stories or undervalued companies because they essentially assume the companies will always be broken and that laggards will always lag. But new management strategies frequently emerge and cyclicals don’t always lag.
Interestingly, the design of the low vol products can come in handy for quantitative long/short equity strategies. Because an ETF’s structure and rebalancing dates are commonly known, hedge funds can get ahead of the fund flows from the periodic rebalancing. They can model which constituents are likely to be sold and bought on the rebalancing date. They can therefore play the flows by shorting the ETF’s expected sells and going long the ETF’s expected buys in advance of the rebalancing date. Front running an ETF rebalancing is not rocket science.
“Smart beta” is catchy marketing. But low vol ETFs, like other factor-based ETF investing, don’t seem all that smart.
Copyright © Thornburg Investment Management