If investors keep following trends and chasing returns, someone will take the other side of smart-beta trades.
“No más.” One of the most memorable boxing matches in history ended when those two words were uttered by Roberto Durán in the eighth round of his title rematch with Sugar Ray Leonard in 1980. Nearly 34 years later, Durán’s reasons for walking out of the ring remain a matter of speculation and controversy. Was it stomach cramps? An injury? Or simply frustration at being outclassed by an opponent he had beaten soundly a scant five months earlier? Regardless, his quitting sent shockwaves through his native Panama and the entire boxing world. For Durán was the quintessential tough guy. He grew up on the hard streets of Panama City and became a professional fighter at the age of 16; his brawling style spawned the nickname “Manos de Piedra” (hands of stone). If there were “a least likely to quit mid-fight” award, Durán would win it hands down. But, whatever the reason, he just couldn’t take it any longer.
Like prizefighters, investors can take quite a beating. Sometimes the blows are absolute, catastrophic losses. But more often the jabs and uppercuts come in the form of relative shortfalls. Fortified with long investment horizons, diversified rosters of managers, limited short-term liquidity needs, and ample risk tolerances, most investors should be tough enough to absorb the punishment. But all too often they, too, are sorely tempted to give up the good fight and abandon their convictions in the middle rounds. Hope fades, and they sell the stocks that have lost value. Desperation sets in, and they buy stocks that have already appreciated, on the chance they might continue to rise. In short, they quit.
Selling recent losers and buying recent winners is the antithesis of the systematic rebalancing discipline through which smart beta strategies earn long-term excess returns. Indeed, we contend that this procyclical behavior is what pays, over time, for the value added by fundamentally weighted index investing and other smart beta strategies.
Smart Betas Trading
To us, the smart beta moniker refers to rules-based investment strategies that use non-price-related weighting methods to construct and maintain a portfolio of stocks.1 The research literature shows that smart beta strategies earn long-term returns around 2% higher than market capitalization-weighted indices. Moreover, smart beta strategies do not require any insight into the weighting mechanism. One can build a smart beta strategy with any stock ranking methodology that is not related to prices, from a strategy as naïve and transaction-intensive as equal weighting to a more efficient approach such as weighting on the basis of fundamental economic scale. For example, a low volatility portfolio and its inverse, a high volatility portfolio, both outperform the market by roughly 2%—as long as they are systematically rebalanced.2 It is not the weighting method but the rebalancing operation that creates most of smart beta’s excess return. Acting in a countercyclical or contrarian fashion, smart beta strategies buy stocks that have fallen in price and sell stocks that have risen.