Sticking To The Basics Of Smart Beta Investing

In a world of new products, factors and strategies, it can be easy to forget about the basics of investing, and to stick to something that works. Justin Sibears, managing director of Newfound Research, says that it’s the basics that will work over time, no matter the ups and downs in between. Ahead of his keynote speech at the Inside Smart Beta conference in New York on Sept. 22 and 23, Sibears explains why investors should not rely on backtests, to have conviction, and not to invest in any strategy that appears to be overly complicated in order to justify a higher fee.

Inside ETFs: Can you elaborate on how to differentiate between a fad and a genuine strategy?

Justin Sibears: In my mind you have to distinguish between a trend or a fad and a really sustainable way to manage money in your portfolio. It comes down to data, having the knowledge that you can prove it works over time and really understand why it works.

One of the big problems is that when it comes to evaluating a strategy, it starts and ends with performance, without people asking why. It’s really the “why” part that’ll indicate whether that backward-looking performance can be repeated going forward.

Inside ETFs: How do you define a fad?

Sibears: When picking a strategy, you need to be grounded in data. As for one fad sticking around or not, that’s up to the market, but for me, there are plenty of ways to invest, with a huge amount of data to support it.

Inside ETFs: How much of a problem is that, in terms of products with no supportive data that are being peddled to investors?

Sibears: I think it’s a big problem. In a lot of cases, the data is very simple, which presents issues for managers trying to make money. If it’s momentum, for example, then simply buy things that are up over the last 12 months. And in a world where you’re trying to justify your fee, there’s a tendency to overcomplicate things to make you seem smarter than everyone else.

There’s value in being simple. It’s hard for the average investor to stick to an approach, in the same way that it’s hard for an active manager.

Is there an easy way to evaluate performance and understand how it works?

Sibears: There’s not an easy way in the sense that there is not a definitive answer. Whether it’s value or momentum, no one knows with 100% certainty why it works. But there are theories that exist.

There are two camps of thinking with momentum—those who believe that momentum takes advantage of behavioral biases of many investors, which causes these trends to exist. The other is the risk camp, meaning that taking risk is associated with generating returns.

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.

That’s not to say there isn’t a way to be active and successful at it. Being systematic is a big part of it, and many people [active managers] have not managed money in a systematic way historically.

Inside ETFs: Would you include back-tested data as a good source for evaluating and understanding performance?

Sibears: I think that backtests are meaningful for setting expectations. So if someone shows me a backtest that’s never underperformed, I wouldn’t trust that. For me, the value of a backtest is to understand when it might do well and when it might do poorly, and in what type of environment. But generally, you want to see strategies that have success on a nonbacktested basis.

Summing up, before I get to the point of looking at a backtest, I should have conviction about whether I want exposure to that type of strategy to begin with. I need to believe that momentum investing, for example, adds value, and why it adds value. I can’t get that conviction because of a backtest.

Inside ETFs: What’s the one practical take away from your speech?

Sibears: The most practical takeaway is to identify ways of managing money that are grounded to data.

Momentum, value, low volatility. Start with a very-well-grounded approach to investing and have the ability to stick to it. Realize that you’re going to underperform sometimes, but those strategies only work over the long run and you need to be committed to owning it.

Warren Buffett said that if you’re not willing to own a stock for 10 years, then you shouldn’t own it for 10 minutes. It’s the same with these strategies.

Inside ETFs: Is there anything else you would want to tell investors before your keynote speech at the Inside Smart Beta conference?

Sibears: One big argument that people present to fight momentum as a valuable tool is that people tend to chase returns, and we know from the data that individual investors don’t tend to achieve that as they go in and out too much.

But because people behave that way, they aren’t as disciplined and systematic as the average momentum investor, so when they chase returns in that haphazard way, they’re creating an opportunity that we can take advantage of in a systematic way. What may seem as evidence against momentum is actually why momentum works in the first place.