The Half-Life Of Smart Beta

October 23, 2013


Whither The Low-Volatility Effect?
If irrationality is the primary cause, it should be self-limiting, as uber-rational or contrarian investors swoop in to take advantage of undervaluations. If they are prevented from swooping in because of constraints, we can be relatively sure that these constraints are indirectly responsible for the low-volatility effect.

It may be too soon to evaluate the effect of low-volatility inflows on the strategy’s excess profits. But constraints need not last forever. The recent surge of investor interest into low-volatility investments has demonstrated this, as has the push among some investors to declare low volatility a separate asset class. Indeed, between May 4, 2011—which saw the debut of Invesco PowerShares’ SPLV—and July 9, 2013, investors plowed $12.3 billion into low-volatility equity ETFs. If low-volatility investments become fashionable, or are no longer evaluated in terms of their information ratio relative to a cap-weighted benchmark, then long-only low-volatility portfolios become feasible and included in many port­folios. Is it any wonder that in recent months the PE ratios of popular low-volatility strategies have surpassed those of their cap-weighted source universes? The low-volatility anomaly may have been eliminated by its popularization.

The Future Of Factors
This leaves factor investing in an interesting place. We have seen factors identified, explained and often diminished after being made public. The market finds a way to properly value erstwhile anomalies, while pricing in actual risks.

After all that, are investors better off in smart-beta products or in cap-weighted indexes? Although each type will dominate, performancewise, in different market conditions, the market becomes more efficient over time as research reveals various effects, and as the market structure evolves to eliminate trading and informational frictions stand. Those investors who can bear larger risks ought to earn rewards over time, even if those risks are never adequately measured by the single-factor CAPM or by evolving multifactor models.

Even if the CAPM proves irrelevant, today’s markets are remarkably efficient. High-frequency trading and quantitative hedge funds had no seats in Benjamin Graham’s stock exchanges. Today, armies of traders vie over fractions of a penny, on multiple exchanges, all day long. Detectable mispricings now last for microseconds. Smart beta approaches rely on significant market mispricings, followed by corrections, in order to deliver superior performance. That’s a high hurdle in the current market.

The benefit of a cap-weighted index is that it encapsulates the opportunity set, and allows the opinions of all market participants to determine the price and weight of your investment. Any portfolio other than a cap-weighted index represents a set of active bets.

Smart beta makes me nervous, because I cannot see how it ends well. I can see the benefit of constructing indexes that are designed to take advantage of risk premia such as illiquidity, default, minority interests, etc. I can see the advantage of designing indexes to avoid these risks, as well. What makes me nervous is the phalanx of academics and marketers who are working to convince investors that there is a free lunch in the marketplace.

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20 McLean, R. David and Jeffrey Pontiff, “Does Academic Research Destroy Stock Return Predictability?”, May 2013
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22 McLean, R. David and Jeffrey Pontiff, “Does Academic Research Destroy Stock Return Predictability?”, Working Paper, 2013
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28 Baker, Malcolm, Brendan Bradley and Jeffrey Wurgler, “Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly,” Working Paper, Harvard, 2010


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