Trying to time the market is a dumb idea.
That in a nutshell is Cliff Asness’s opening salvo into an escalating war of words over smart-beta exchange-traded funds, triggered in February when one of the inventors of the approach said many had become too expensive. Asness, co-founder of AQR Capital Management, joins other theoreticians jumping in the fray, which goes to the heart of a strategy that bridges active and passive management.
While the debate has an academic ring, a lot is riding on who’s right. Smart-beta styles underlie about one in five ETFs globally with an estimated $400 billion under management, and if they plunged, millions of investors would be burned. The technique seeks to soup up index returns by ranking companies not by size but other properties or “factors” -- like what they earn or pay in dividends.
“This is a good conversation that’s happening,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Global Market Intelligence. “It’s good for the broader asset management industry to have an ongoing conversation about the merits of smart-beta products because they aren’t perfect -- they’re not gospel.”
At the center of the squall is Rob Arnott, star manager for Pacific Investment Management Co. and one of the founders of the discipline, who sent seismic shocks through investing circles in February with a paper warning that a bubble is forming in smart-beta funds. Many strands of the investing style succeeded only because of a stampede in popularity, and they are poised to crash, he wrote.
Siren Song
Enter Asness, the 49-year-old hedge fund manager who has argued in past research that valuation tools such as the Shiller price-earnings ratio have limited use for market timing. In a new paper titled “The Siren Song of Factor Timing” that’s mostly a response to Arnott, he said popping in and out of assets based on valuations is rarely a good idea and the principle applies no matter what wrapper stocks come in. In Greek mythology, the sirens were half-birds, half-women who used their beautiful voices to lure sailors into shipwreck.
“Factor timing is very tempting and, unfortunately, very difficult to do well,” he wrote, before explaining and defending his position in a series of e-mails over the weekend. “Nary a presentation about factors, practitioner or academic, does not include some version of ‘can you time these?’ or ‘is now a good time to invest in the factor?’ I believe the accurate answer to the first question is ‘mostly no.’ ”
Factor Timing
Timing smart-beta strategies by buying when cheap and selling when valuations are higher is ultimately dangerous, according to Asness. Smart-beta managers have an incentive to claim they can do this as they seek to defend higher fees, but it’s unlikely that they can, he says. It’s better to have diversified exposure to a mix of factors that work over the long term, he said. If investors do decide to time factors, they should only do so a little, he says.
“I think that siren song should be resisted,” Asness wrote. “At least when using the simple ‘value’ of the factors themselves, I find such timing strategies to be weak historically, and some tests of their long-term power to be exaggerated and/or inapplicable.”
Arnott, chairman and chief executive officer of Pimco sub-adviser Research Affiliates LLC, has gone from being an icon of his industry to one of its biggest detractors. He said in February that many versions of smart beta were performing well only because of their popularity, with the exception being those tuned to cheap stocks -- a style in which his firm specializes and which has fallen out of vogue.
Performance Chasing