“These strategies go in and out of favor,” Melissa Brown, managing director of applied research at Axioma Inc., said by phone. “If you’re going to combine them, you’ve got to be smart about combining them.”
Compare Deluard’s DUMB portfolio with the five individual smart-beta ETFs he used, and the winning characteristic is clear. MTUM outperformed by 18 percent through April as winners kept on winning and investors continued to buy the trend. Meanwhile, QUAL, which aims to track companies with high return on equity and low debt burdens, beat DUMB by 1 percent. And the three other smart-beta strategies fell short.
When you combine factors without a guiding principal or reason, you also could end up with factor dilution -- the idea that the conviction of a factor is lessened when mixed with others, according to Mark Carver, head of factor index products at MSCI.
Multiple Outcomes
“You end up with something that is closer to the benchmark than getting factors,” he said in an interview at MSCI’s New York office. “And if you do that across four different ideas, you’re diluting your ultimate exposure to the factors. You’re not even representing what that factor portfolio could look like in a well-designed sense.”
Plus, not all smart-beta ETFs are meant to beat the market at all times, according to BlackRock. Instead, they can be used for different purposes. Funds that select companies based on their dividend yields could provide quick income for investors, for example.
“Investors recognize that factor investing offers multiple strategic outcomes such as improving returns, reducing risk and increasing income,” BlackRock said in a statement. “Short-term performance is not an indication that a factor strategy is working.”
Facing Skepticism
Across the industry, firms are preaching smart-beta to the masses, focusing on teaching investors how to use factor-based strategies effectively. OppenheimerFunds Inc. has gone the creative route, inviting investors to “race” their portfolios a-la the Kentucky Derby, educating along the way. BlackRock Inc. launched a free online tool that users can use to analyze stock funds with a factor lens.
Still, it’s not the first time smart-beta products have faced skepticism, and Deluard’s concern that factor-based ETFs lose their market-beating value as they grow in popularity sounds similar to worries previously presented by Rob Arnott, chief executive officer of Research Affiliates.
Two years ago, Arnott, one of the founders of smart-beta, wrote a paper warning that most of the ETFs were only succeeding because of their growing popularity with investors and henceforth inflated valuations. Ultimately, the strategies are poised to crash, he argued.
This article was provided by Bloomberg News.