Smart beta, or strategic beta as it’s sometimes known, has become very popular in recent years. More and more advisers are trying to use smart beta to produce market-beating performance without the need to pay active management fees.
But smart beta funds are still more expensive than traditional index funds, and they do have their downsides. In the fifth and penultimate article in this series on the cost of investing, we investigate whether advisers should be looking to include an element of smart beta in their clients’ portfolios.
Much has been made over the last few years of so-called smart beta. Different people call it different things; for example, strategic beta, fundamental indexing or factor investing. But what exactly is it? And, given these sorts of funds are more expensive than cap-weighted index funds, should advisers should be recommending them to their clients?
In simple terms, beta refers to the market return; alpha refers to any returns that an active fund manager is able to deliver over and above the market return. In practice, consistently delivering alpha net of costs is extremely difficult, which is why a market-cap-weighted fund like the Vanguard Total World Stock Index Fund is such a sensible option.
But are there certain sections of the market that tend to deliver higher returns than the overall market over the long term? Research conducted by the Nobel Prize-winning economist Eugene Fama and his colleague Kenneth French suggests that there are.
The different factors
What Fama and French discovered was that, over the long term, stocks of smaller companies outperform those of larger companies, and stocks of undervalued companies (or value stocks) outperform growth stocks.
To those size and value factors (or risk premiums as they’re sometimes known) they have since added a third factor, profitability; in other words, over time, stocks of companies with high profitability generally outperform those with low profitability.
Although their primary focus has been on US securities, Fama and French have also observed these risk premiums working in financial markets around the world. Data from Dimensional Fund Advisors shows, for example, that in the ten-year period to the end of 2017, UK small-cap stocks outperformed UK large-cap stocks on an annualised basis by a whopping 4.91%.
There are, however, significant downsides to tilting a portfolio towards these different risk premiums. First and foremost, there is no guarantee that the size, value and profitability factors will outperform in the future to the same degree that they have in the past. Indeed no one can be certain that they will beat the broader market at all.
There are some who suspect that the value factor, for instance, has stopped working altogether. In that same ten-year period referred to earlier, UK value stocks have underperformed growth stocks by an average of 4.02%. High-profitability stocks have also underperformed low-profitability stocks in the UK — by 1.92% a year — although they have outperformed in Europe, the US and the emerging markets.
Another problem with small-cap and value stocks is that they carry greater risk than the market as a whole. Nor is it possible to predict when a particular premium is about to show up, because outperformance tends to come in random bursts.
A long time horizon is essential
Over the longer term, however, the case for factor tilts is much stronger. Dimensional’s data shows that, for ten-year rolling time periods, size has outperformed growth 83% of the time in the UK since January 1970; value has outperformed growth 78% of the time since January 1975; and high profitability has outperformed low profitability 83% of the time since January 1990.
Another reason why it’s especially important for factor investors to have a long time horizon is that small-cap and value stocks are imperfectly correlated. In other words, they outperform and underperform the rest of the market at different times. So, the shorter the time horizon, the more unpredictable your returns will be. The longer you invest for, the easier it will be to harvest the returns of the different premiums.
Given sufficient time, factor investing also works in the fixed income space. Academics have identified two main factors that tend to produce higher bond returns. The first is term premiums; in other words, bonds with distant due dates have returned more than bonds that are due soon. The second one is credit premium; that is, bonds with lower credit ratings have returned more than bonds with higher credit ratings.
But is it worth it?
So, is a financial adviser justified in recommending smart beta funds to a client? There is certainly plenty of data to justify allocating at least part of a client’s portfolio to factor-based funds.
There are, however, important caveats. First, of course, you need to ensure that any additional returns more than compensate for the additional expense the client will incur compared to investing in a low-cost index fund.
Crucially, you also have to manage the client’s expectations. These risk premiums won’t shoot the lights out, especially over short time periods. The client has to be willing to stick with their strategy for a very long time. And because small and value stocks are likely to fall even further than the broader market in a crash or correction, factor investors need to be even better able to handle extreme volatility than cap-wighted indexers.
Most important of all, remember that there’s no guarantee of outperformance. Smart beta only offers the possibility of beating the market. It may or may not happen. Just because these risk factors have produced a premium in the past, that doesn’t mean that they will continue to do so in the future.
Smart beta, then, may suit some clients, but for investors who simply want to capture market returns cheap and efficiently, traditional cap-weighted index funds may be a better option.
In case you missed any of them, here are the first four articles in this series:
What is the impact of fees and charges on returns?
What does cost tell us about future performance?
How do you work out the total cost of investing?
Should an adviser ever recommend an active fund?