A few years ago Vincent Deluard was a huge cheerleader for smart-beta ETFs, which slice and dice the market using indexes tuned to classic investing factors like momentum and value.
But times change and so has Deluard’s take on factor-based exchange-traded funds. With smart beta portfolios becoming increasingly popular, the global macro strategist at INTL FCStone Financial Inc. recently reached the conclusion that the strategies aren’t as shrewd as they seem. So he set out to prove it by building his own “DUMB” portfolio. The results were enlightening.
“If everyone’s doing it, it’s not going to work anymore,” Deluard said.
This is a significant change of heart for a 35-year-old Wall Streeter who’s spent the past 10 years enamored with the quant theory. Deluard even helped build a multifactor smart-beta ETF. But he said working behind the scenes was a disconcerting experience.
“The more I’ve seen this become mainstream, and the more I see how easy it is to fool people with facts -- some long-term backtests, short-term stats -- you realize quickly you can really prove anything,” Deluard said. “My faith in quant academic finance has really come down quite a bit.”
Factor Proliferation
Use of factors in ETF investing has exploded in the past few years. Assets under the smart-beta umbrella in the U.S. have almost tripled since 2012, reaching about $600 billion in 2017, according to data compiled by Bloomberg. Since 2017, issuers have started 67 new smart-beta ETFs, according to BlackRock Inc. The firm estimates that factor strategies will grow to $3.4 trillion by 2022, while smart-beta, a subset of the broader factor world, will reach $1.4 trillion.
To test the genius of the smart-beta industry, Deluard spent Nov. 7, 2016 -- the night before the presidential election -- concocting an experiment. He created what he called a “basket of deplorables,” an index made up of the outcasts of the smart-beta world, which he named DUMB. To do it, he put together a market-capitalization weighted index with about 200 companies that are in the S&P 500 Index but didn’t make the cut for these five factor-based funds:
iShares Edge MSCI USA Quality Factor ETF ( QUAL) ProShares S&P 500 Dividend Aristocrat ETF ( NOBL) iShares Edge MSCI USA Min Vol USA ETF ( USMV) iShares Select Dividend ETF ( DVY) iShares Edge MSCI USA Momentum Factor ETF ( MTUM)
He then combined those five smart-beta funds to create an equal-weighted portfolio that he named SMART. From the experiment’s start through April, the most recent period for which the data is available, DUMB beat SMART by more than 2 percent. Deluard says he remains bullish on the “DUMB beta” index, in part because he expects rates to rise and most smart-beta funds have a negative correlation to yields, he said.
A Bloomberg portfolio analysis shows Deluard’s hypothetical fund benefited from positive exposure to financials, which made up about 30 percent of the holdings, as well as its positions in profitable and cheap companies.
Of course, there are caveats. Many portfolio managers would argue that a year-and-a-half isn’t long enough to draw a conclusion on an investing thesis. Plus, equally weighting five different smart-beta ETFs doesn’t really mimic the reality of what the industry is trying to do. The point of the strategy is that different factors work in different market environments, so an investor probably wouldn’t want equal exposure to these characteristics at the same time.