The dirty little secret behind “smart beta” investing

Some minor buzz has arisen among finance academics and professionals as a result of a paper by Ronald Kahn and Michael Lemmon, both of whom are employed by Blackrock, entitled The Asset Manager’s Dilemma: How Smart Beta Is Disrupting the Investment Management Industry. Here is the abstract:

Smart beta products are a disruptive financial innovation with the potential to significantly affect the business of traditional active management. They provide an important component of active management via simple, transparent, rules-based portfolios delivered at lower fees. They clarify that what investors need from their active managers is pure alpha—returns beyond those from static exposures to smart beta factors. To effectively position themselves for this evolution in active management, asset managers need to understand the mix of smart beta and pure alpha in their products, as well as their comparative advantages relative to competitors in delivering these important components.

As Blackrock is a supplier of “smart beta” fund products, are these authors talking their own book or is this truly a new form of financial disruption?

A history lesson

To truly understand the underpinnings of “smart beta”, we begin with a history lesson, starting with the advent of the Capital Asset Pricing Model (CAPM). According to Wikipedia, Treynor and Sharpe formulated CAPM to explain stock returns this way:

In plain English, CAPM explains the sensitivity of a well-diversified stock portfolio by its beta. In an era when investment professionals just picked stocks, CAPM was an enormous leap forward in financial innovation. Portfolio managers suddenly had a dial called beta. If you were bullish on the market, all you had to do was raise the beta on the portfolio. Conversely, if you were bearish, you could become more defensive by reducing portfolio beta.

In the wake of CAPM innovation and its sister theory, the Efficient Market Hypothesis (EMH) which postulated that you couldn’t beat the market, great controversies erupted. Throughout the 1970s, academics found a number of “market anomalies” such as market capitalization (small cap), value anomalies such as low PE and low PB. Well-diversified (underline the words well-diversified) portfolios using these techniques did in fact beat the market.

There were further problems with CAPM that led to the financial theory behind smart beta. Imagine that you formed two well-diversified portfolios with similar betas, the first composed of oil stocks and the second composed of airline stocks. We know that these two portfolios will behave very differently in the face of an oil shock, which is contrary to the expectations specified by CAPM.

Stephen Ross formulated the Arbitrage Pricing Theory (APT) by decomposing market beta in CAPM into a number of unspecified factor betas. Portfolio returns could be explained by a portfolio`s sensitivity to different factor betas, such as different sectors, or macro sensitivity such as interest rates, housing starts, inflationary expectations and so on.

Thus, factor investing was born.

Fabozzi on factor investing

CFA candidates are well aware of Frank Fabozzi, who is now a professor at EDHEC Business School. In a recent interview, Fabozzi described factor investing this way:

The belief is that if you invest in factors, you can either provide a return in the long term that will be in excess of the return on a capitalization-weighted index, or provide a better diversification format.

So which is it? Is factor investing better diversification (better beta) or a way of beating the market (alpha)? Fabozzi went on:

So that`s where it stands right now for factor-based investing strategies. They can still be active or passive strategies, but the search is still for things such as are there factors that continue to provide a risk premium over time – and that will always be an empirical issue. Some market participants talk about pure factors. What they really mean is time-tested factors that have delivered a risk premium…

…And it`s an empirical challenge; there is no underlying theory about these factors. There are economic reasons or behavioral finance reasons why you might expect a factor to be rewarded. Behavioral finance theorists do a very good job of explaining that link, but the empirical work will go on.

In other words, these factors seem to work, but nobody can really explain why.

1980s technology in a new package

Cam here. Let me explain how I once used factors as a quantitative portfolio manager to pick stocks. We would combine different uncorrelated factors, such as growth and value, to engineer a stock selection process. Further, we would selectively turn factors off and on by sector. For example, a factor like low PE may work reasonably well in a sector grouping like banks, but you would not use it to pick technology stocks because low PE technology tended to be markers for the busted growth companies that have lost their competitive position. On the other hand, a momentum or growth factor like estimate revision is probably appropriate for most sectors.

These are the kinds of techniques that quants have been using since the 1970s and 1980s to pick stocks. Today, factor investing techniques are easily accessible. Everyone has the same databases. They all look at the same factors, though the formulations are slightly different.

Blackrock et al has just re-packaged factor investing as “smart beta” as a way to sell funds. While some of these factors can and do work over time (so does “value”, “growth” and “momentum”), but they don’t work all the time and investors may have to exercise a great deal of patience (see Where I am finding value in today’s market).

The true financial innovation does not come from the factor investing technique, which is well know. Rather, itcomes from how factor investing is marketed. That’s because this marketing technique absolves the portfolio manager from poor performance. The Kahn and Lemmon paper states:

Smart beta products change the division of responsibility between investor and manager. An investor can fire an active manager who underperforms the cap-weighted benchmark over time. The investor is responsible for hiring the manager, and the manager is responsible for outperforming the benchmark. But an investor should not fire a smart-beta manager who delivers the promised exposures if those exposures lead to underperformance. The investor, not the manager, is responsible for the choice of those exposures.

In other words, you, the investor, takes all the risks for picking the factor, or “smart beta” that the fund company peddled to you. Heads they win and tails they win.

Is this financial innovation and disruption? It is, but only for the fund companies.