A Hot Investment Style Looks Great in the Rearview Mirror
Investment vehicles designed based on past performance might just disappoint in the future.
Bloomberg, July 12, 2017
Our story thus far: After decades of expensive and often underperforming active fund management, the public has embraced low-cost, passive-index investing with a vengeance. The old chin-rubbing-this-company-looks-good school of stock picking has been hit with enormous asset outflows. Vanguard Group Inc. and BlackRock Inc. have captured trillions of dollars in new assets, tied to broad indexes, to the collective detriment of active money managers. 1
Into this maelstrom of capital reallocation steps smart beta, or fundamental indexing, which straddles the line between active-stock selection and passive investing in vehicles tied to things like the Standard & Poor’s 500 Index. By using other criteria for creating indexes — historical dividend growth, earnings, price-to-sales ratios and so on — smart-beta managers are attracting assets where other active managers are not. Morningstar data (reported by the Financial Times) shows that $866 billion is managed in this way, up 207 percent since 2012.
The growth makes sense from several perspectives. The rise of smart beta lets securities firms charge more than low-cost providers such as Vanguard; it also gives an outlet to those who want to be more active than plain-vanilla indexers are in their investment selections. Fundamental indexing seemingly provides a benefit for all participants.
Alas, there is no free lunch. Fundamental indexing is drawing more scrutiny, and greater concern about how these indexes are assembled. Numerous critics, from both within and without the fundamental-indexing firmament, have identified potential problems with this investment style.
Start with Andreas Utermann, global chief investment officer for Allianz Global Investors, who wrote “smart beta is neither smart nor beta.” That’s a fair criticism coming from an active manager about what has been derided as little more than a marketing slogan.
A stronger criticism comes from within, via one of fundamental indexing’s creators and biggest proselytizers: Rob Arnott, founder of Research Affiliates. As Bloomberg Newsreported earlier this year, “more than $17.5 billion in ETF assets follow Research Affiliates’s RAFI smart beta indexes.”
In a white paper published in 2016, Arnott 2 warned about a significant potential risk for the genre: designing fundamental indexes based on form-fitted backtests of new factors. In “How Can ‘Smart Beta’ Go Horribly Wrong?,” Arnott writes:
Many of these alpha [above-market returns] claims are based on a 10- to 15-year backtest that won’t cover more than a couple of market cycles. Second, such a short time span is very vulnerable to distortion from changing valuations. Our analysis shows that valuation has been a large driver of smart beta returns over the short and even long term. How much can we reasonably expect in future returns from these factors and strategies, net of valuation change? For some strategies perhaps a great deal, and for others, not much.
That is a fair, if not muted, criticism of the dangers of backtesting.
A more full-throated critique came recently from Antti Suhonen of Aalto University in Finland. In a recent Journal of Portfolio Management paper titled “Quantifying Backtest Overfitting in Alternative Beta Strategies,”3 Suhonen reviewed the “daily returns of 215 alternative beta strategies across five asset classes, eleven identifiable strategy groups, and fifteen sponsor investment banks.”
The results, he wrote, “strongly support the existing literature on selection and publication biases and backtest overfitting.” In other words, an index designed based on past results didn’t result in the same sort of outperformance once the strategy was deployed in the real world.
Perhaps the strongest criticism of fundamental indexing comes from Clifford Asness, chief investment officer of AQR Capital Management LLC. Asness has been involved in an ongoing debate about whether fundamental indexing is little more than risk premia attributable to classic Fama–French factors (factors are things like value, momentum, capitalization size, quality, etc.). He makes a compelling case that most of the above-market returns generated by smart beta is really factor investing in disguise.
Speaking of Nobel laureate Eugene Fama and Kenneth French: We would be remiss if these two weren’t mentioned in any discussion of fundamental indexing. The two professors consult for what is arguably the most successful of the factor investors, Dimensional Fund Advisors LP. Founded 36 years ago, DFA now manages about $500 billion in assets, using academically derived factor models. Its approach to factor investing was decades before anyone else even conceived of smart beta as a marketing slogan. Dimensional proudly notes its performance record: Although only 15 percent of equity and bond funds in business since 2000 beat their benchmarks, more than four-fifths of Dimensional funds have outperformed during the same period.
Regardless, fundamental indexing has become popular for very specific reasons. There are no signs that its attractiveness or growth is slowing. But the backtesting issues of the newer smart-beta products could be cause for concern. Investors expecting to outperform are advised that they may be disappointed. Please proceed cautiously.
1. Disclosure: My own personal portfolio is primarily invested in Vanguard and Dimensional Funds, as are clients of Ritholtz Wealth Management
2. With co-authors Noah Beck, Vitali Kalesnik and John West.
3. Citation: “Quantifying Backtest Overfitting in Alternative Beta Strategies;” Journal of Portfolio Management 43(2), 90-104, 2017, with co-authors Matthias Lennkh and Fabrice Perez.
4. Batnick is head of research at Ritholtz Wealth Management.