Rules-based investing existed for decades before the introduction of so-called smart beta funds about 14 years ago. Since then, however, numerous variants of the strategies have exploded in the institutional and advisor universe.
Questions about rules-based investing, among other topics, came up for discussion on March 22 when Financial Advisor and JV Events convened a roundtable at their first Investing in Smart Beta event in Fort Lauderdale, Fla. The roundtable occurred only a month after one of smart beta’s intellectual pioneers, Rob Arnott, founder of Research Affiliates, wrote a paper arguing that the strategy was becoming a victim of its own success and said there might be a “smart beta crash.”
Product proliferation in the space was metastasizing into performance chasing and what Arnott labeled an “alpha mirage.” That, in turn, was creating market distortions and the overvaluation of certain asset classes, particularly defensive, low-beta stocks like telecommunications, utilities and consumer staples. Coming when they did, Arnott’s comments provided fuel for a lively discussion at the roundtable.
Even experts find themselves challenged when defining smart beta, though that has done nothing to stem the flood of assets into the category. According to roundtable participant Deborah Fuhr, managing partner of research firm ETFGI and chair of the conference, smart-beta ETFs now represent about $400 billion in assets.
In her view, smart beta strategies reside somewhere on a style spectrum between traditional active investing and purely passive indexing vehicles from both a cost and a conceptual standpoint. Typical smart beta products trace their design to academic research of varying degrees, often trying to identify systematic sources of alpha and risk control behind the strategies.
Many of the first ETFs focused on dividends, Fuhr said. They were targeted at income-oriented investors and used mutual fund category labels, not smart beta. Of course, a decade ago the fixed-income universe offered investors more inviting yields than they do today.
Smart beta truly came of age after the financial crisis prompted central banks around the world to embrace quantitative easing and near-zero interest rates. The changing yield environment spawned all sorts of investment vehicles, and smart beta ETFs focused on dividends were conspicuously popular.
Asset management complexes quickly realized there was an emerging demand from frustrated income investors. To enhance ETFs’ appeal to conservative retirees in the post-crisis world, a cousin of equity-income ETFs quickly surfaced with the label of low- or minimum-volatility funds, and the wave became a flood.
Once upon a time, serious investment thinkers tried to find sources of excess returns in unloved or overlooked asset classes. Academics Eugene Fama and Ken French, credited with creating factor investing, identified small-cap equities in the 1970s and low price-to-book value stocks in the 1990s as sectors that could deliver excess returns. “Factor investing was a way to add value to clients,” said Lukas Smart, vice president at DFA, at the FA roundtable.
A major motivation behind Arnott’s theory of fundamental indexing, or equal weighting of companies with different market capitalizations, was avoiding over-concentrations of risk and excessive valuations. It’s no coincidence his research began in 2000, when a handful of mega-cap technology companies dominated the S&P 500.
A Crowded, Pricey Space
Over the last 15 years, the investing world has been turned upside down, and value investors now have valid reasons to question the crowded equity income/low volatility space. Defensive stocks, so boring in the late 1990s, offer generous dividends and slow non-cyclical earnings growth, attributes advisors and clients now appreciate.
It’s not just equity-income funds and low-volatility ETFs driving valuations of companies with predictable earnings streams. Some respected equity strategists like Thomas Lee of Fundstrat continue to recommend these and other equities, arguing that blue-chip stocks “are the new bonds,” many with equity yields exceeding their bond coupons.
To skeptics, that wouldn’t be so serious a problem if many holdings didn’t sport price-to-earnings multiples of 24 or more, valuations once reserved for real growth companies, not low- to mid-single-digit growers like Pepsi, Coke and Clorox. Campbell Soup struggles to grow its top line, but sells at 28 times earnings.
Further propelling this sector’s valuations are persistent rumors in recent months that Brazilian private-equity firm 3G and Warren Buffett are looking for more acquisitions in this space after buying both Kraft and Heinz.