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.

Of course, low-volatility ETFs were designed in recent years to provide investors with both income and stability, and it’s quite possible they can continue to do so—only without the capital appreciation. “People have seen excess returns from low volatility over the last 15 years, but it’s not sustainable,” said roundtable participant Brent Leadbetter, vice president of client strategies at Research Affiliates.

Still, context is critical. Outcomes-based investing has served as a major theme at BlackRock, and Holly Framsted, a strategist on the iShares equity smart beta team who sat at the roundtable, said people shouldn’t be that surprised that most clients have increased their equity risk exposure in a low-growth, low-yield world. The more pertinent question is what problem they are trying to solve.

If clients want to remain in equities and lower their risk, minimum volatility ETFs can work, Framsted noted. It also has to be weighed against the potential unintended consequences of going into high yield, where clients could be getting equity-like risk without the upside of rising dividend income. “It’s not all about performance; it’s also about risk reduction,” she added.

What Smart Beta Needs
Nonetheless, smart beta needs a new next big thing. The search for other sources of return is one reason factor investing is enjoying a resurgence. Value, momentum, size and quality (or profitability) are among the strategies that smart beta strategists are revisiting.

Some are thinking outside the box and trying to blend smart beta with other strategies like risk parity, which focuses on the allocation of risk rather than capital. That lies behind the JP Morgan Diversified Return International Equity approach, in which avoiding overconcentration is a key goal.

Many investment strategies deliver most of their value by dodging big losses, said roundtable participant Nigel Emmett, managing director at J.P. Morgan Asset Management. Risk parity means, among other things, he doesn’t have to project returns but can zero in on risk levels in various sectors and asset classes. His fund seeks to equally allocate risk as measured by the Sharpe ratio, value, momentum, size and low volatility across 40 different regional sectors.

“It is a different series of returns and it leads to a different upside-downside risk capture,” Emmett said. The goal is to perform “as well or a little better” in good markets and “noticeably better” during down markets.

Blending multiple factors could be a strategy ripe for new innovations if the success of the DoubleLine Shiller Enhanced CAPE fund is any indicator. Though less than three years old, this mutual fund has combined value with a twist on momentum, actually negative momentum, and earned a spot in the top 1% of Morningstar’s large-cap value universe in 2014 and 2015.

The fund’s methodology ranks the old 10 S&P 500 industrial sectors by various metrics from one to 10 and then invests in six through nine, reasoning that the bottom sector could well be a value trap. The methodology prompted the fund to dump energy in the fall of 2014.

Jeffrey Sherman, who manages the DoubleLine fund, noted at the roundtable discussion that value had underperformed growth for nearly four years. But don’t project the past too far into the future, because valuation doesn’t always tell investors when mean reversion is coming. It does, he said, provide some indication of the likelihood of future performance.

“Growth can become cheap in certain [market conditions],” said Sherman during the discussion. “In later [stages] of a credit cycle, you want to avoid high-flyers. People tend to fall in love with certain stocks and sectors.”

One trend advisors can expect to see in the future is more blended or paired smart beta strategies. Quality, or profitability, irrespective of price can be dangerous, but when paired with valuation it becomes more attractive, several panelists noted.

Without six years of unprecedented low interest rates, serious investors would undoubtedly be worried about some other market distortion. Fifteen years ago the distortion problem was the expectation of absurdly unrealistic returns; today it is the result of older investors’ legitimate need for income.
 

Evan Simonoff is Editor-In-Chief of Financial Advisor magazine.