Sticking To The Basics Of Smart Beta Investing

September 20, 2016

The way to get more comfortable with understanding why something works is that you can see it work in many different applications. Take a strategy in the U.S. equity market: It might have worked over the last 15 years, but if it doesn’t work in other countries, I might start to think I’ve found something that just worked by accident—a weird pattern in the data. But if my strategy is applied in 20 countries and works in all of them, I can be more confident that it will generate returns going forward.

Inside ETFs: Do you not agree that, to a certain extent, the investment industry is set up against investors, as there are so many products and marketing departments that want to sell each new product as the next big thing?

Sibears: It’s easy enough to understand performance in a world where there is so much data out there. But in portfolio management, everything tends to be framed as an “either/or” situation. I’m either passive or active. I’m either high cost or low cost. That mindset is supported in this industry as we put out these one-page theses saying you should do things this one way.

One chart that you see many times is the returns of the U.S. stocks market. Here are the 30 best days, it says, and here are the 15 best days, and if you miss these, your returns go down dramatically. The implication is you should always be in the market.

But the data isn’t saying that. It’s saying simply that if you miss the best days, you’ll be out of luck. A lot of times in our quest for the simple sound bite, we take a piece of data and extrapolate this big meaning from it, when actually what it means is a lot more narrow. So we can combine passive and active, and combine strategies. There is not necessarily one way to invest.

Inside ETFs: But if you pick a passive fund tracking the market, you don’t necessarily need to know what’s driving that performance, and therefore you’re not chasing a fad, so isn’t that the safest bet?

Sibears: I wouldn’t say it’s the safest bet. There’s clear data that suggest there are ways to go about factor-based equity investing and do better than buying and holding a cap-weighted index. That makes sense, right, as when I buy a market cap-weighted index, I’m just buying everything. The problem is that people are not always rational, and if they decide to go with a more active approach, they’ll still benchmark to cap-weighted indexes.

If you can’t be consistent in your investment style, you should probably go for a market-cap-weighted index. If being market-cap-weighted keeps you invested and stops you from making poor decisions, that’s going to be a better outcome for you, but that doesn’t mean it could be the best possible outcome. The best possible outcome would be if you can deviate from benchmarks in a consistent way. Just note that if you take a different approach, you’re inevitably going to underperform sometimes.

Inside ETFs: If you invest in an active fund, you can have all the data you want, but a fund comes down to one person’s decisions. So how can that manager consistently beat the market?

Sibears: One unfortunate thing is that big ideas dominate in the investment world, and often it’s based on data that’s used incorrectly or has been used to draw far-reaching conclusions.

So yes, there’s data that active management doesn’t work, but the reality is that most active managers, looking backward at their performance, haven’t employed a consistent approach year-over-year.

 

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