The factor wars have begun.
After Research Affiliates CEO Rob Arnott clarified remarks portending a ‘crash’ in smart-beta investing, many questions surrounding the viability of the concept’s strategies and factors remain.
At Charles Schwab’s Center for Financial Research, alternative beta and asset allocation strategist Tony Davidow agrees with Arnott’s central point — advisors and investors should take care when selecting smart-beta products.
“Not all strategies are created equally,” says Davidow. “Clearly momentum strategies are different from fundamental indexing.”
Davidow is a practitioner of fundamental indexing, a portfolio strategy pioneered by Arnott and Research Affliates where stocks are weighted not by market capitalization, but by fundamental factors such as value, cash-flow and dividends.
“We’re focused on helping people distinguish between the multitude of products and strategies,” Davidow says. “That has to be the starting point.”
In a media call on Thursday, Arnott said that while fundamental indexing is not the only strategy that can result in well-performing smart-beta portfolios, the proliferation of new strategies and factors is leading to a complicated landscape in which some products labeled as 'smart beta' produce the opposite approach.
Arnott argued that academic researchers are using recent past performance as evidence of the viability of a factor or strategy — but that in some cases that past performance is due to the rise in the relative valuation of the strategy, leading practitioners and asset managers to offer products that are buying more expensive stocks rather than harnessing a fundamental driver of alpha.
To untangle valuation from actual outperformance, Arnott proposed dividing alpha into two concepts – structural alpha from the effects of the factor, and situational alpha from the growth in relative valuation of the product.
“It is interesting that Rob says the smart-beta picture is becoming too complex, and he’s now introducing more complexity with a new way to think about alpha,” Davidow says. ”What he’s saying makes sense, some of these strategies are rich in academic history and rigor and that will play out over time, while others are byproducts of short-term phenomena that exist in the marketplace.”