As a speaker at this fall’s Investment Innovation in Palm Beach, Florida (November 4 to 6), Dr. Burton G. Malkiel, Chemical Bank Chairman’s Professor of Economics, Emeritus, and Senior Economist, Princeton University, will talk about the theory behind smart-beta strategies and how they’ve worked out in practice. In advance of the conference, we asked Malkiel a few questions about the various smart-beta strategies, how they work, and when they work. To find out more about Burton’s presentation and the Investment Innovation Conference, click here.
What are your thoughts on smart beta?
Smart beta has become a very popular investment technique and there have been many funds and exchange-traded funds (ETFs) that have relied on so-called smart-beta tilts to the portfolio. My views are first of all that this is active management, not passive investing. Secondly, to the extent that smart-beta techniques lead to higher rates of return, they are simply a reasonable compensation for the extra risk that has been taken. It’s not a real new paradigm, a great new investment technique that will dominate straight passive index investing.
Can smart beta be arbitraged away?
If smart beta is an inefficiency, one would expect that over time it would get arbitraged away. To the extent that smart beta is simply a way of getting some extra compensation by taking on extra risk, it would not necessarily be arbitraged away. That is because you could have a perfectly equilibrium market with some kinds of stocks giving you higher rates of return — if those higher rates of return were not inefficiencies — but simply just compensation for taking on additional risk.
How many sources of additional risk are there, beyond market risk?
The two main tilts that smart-beta funds employ are size and value: that stocks with low prices relative to their book values as well as smaller companies have tended to give higher rates of return. Some smart-beta funds rely on a momentum factor. Some smart-beta funds rely on the fact that the relationship between return and beta is relatively flat, rather than upward sloping as the Capital Asset Pricing Model predicts. Therefore one smart-beta strategy is to buy low-beta stocks – stocks with a beta of less than one – and leverage them up to have a beta of one.
If, over the long term, momentum is mean reverting, is it really smart beta?
You can argue reasonably that smaller companies are riskier. Maybe companies that sell at low prices relative to book values are under some financial distress. It’s much easier to interpret the other factors as risk factors. It’s not nearly as clear a) how you interpret the momentum effect and b) really how dependable this is, since it’s clearly the case that there’s momentum in some situations, but it can reverse itself quite frighteningly. Look, we saw that in markets the other week. The momentum guys said we’re in a downtrend, “sell, sell, sell.” And then all of a sudden it just turns around on a dime.
The performance of these factors is going to depend a lot on market valuations at the time the smart-beta strategy is implemented.
Where did value investing really, absolutely dominate? If you were in the first quarter of 2000, Cisco Systems, a great company, sold at 150 times earnings. My local public utility in New Jersey, Public Service Electric and Gas, sold at 15 times earnings. Boy, was that the time to be in Public Service Electric and Gas because even though Cisco’s earnings went up sharply, Cisco lost 90% of its value. That is because when a price/earnings multiple goes from 150 down to 15, you’re in real trouble. Relative valuations matter and investors need to assess this before embarking on a smart-beta strategy. Given where growth stocks are trading, is today the time that you want to tilt toward value? It’s a question investors have to answer.
How successfully have smart-beta strategies been translated into investment funds?
There has been some mean reversion. Some have underperformed their benchmarks and others have outperformed. Dimensional Fund Advisors has done a good job. They use multiple factors – it’s a little bit of a black box – but they’ve been good. They’ve been doing a lot of work recently on something called quality and whether quality is a risk premium. We’re now getting into some semantic issues. There’s no question that some of these strategies have done well. Rob Arnott, over RAFI’s history, has had excess performance, too
Is the excess return from smart beta enough to move the needle?
It doesn’t move the needle very far, but relative to the benchmark, it could be an extra percentage or two. In a low-return environment, that’s not chopped liver. Is this a huge thing? No, it certainly isn’t because these are very broad portfolios. But if you can give me 100 basis points, I would say boy, that’s terrific. But investors must remember that any excess return that is earned from factor tilting is most likely to result from the assumption of greater risk
To learn more about the Investment Innovation Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Alison Webb to be considered, as limited space available.