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How Smart Is Smart Beta?

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Exploring the Evolution of Smart Beta

In a recent blog post, we made the argu­ment that debate between pas­sive and active man­age­ment is irrel­e­vant. By focus­ing on small dif­fer­ences in rel­a­tive per­for­mance, investors risk los­ing the for­est for the trees. Both pas­sive and active man­agers are heav­i­ly exposed to mar­ket risk. Also known as sys­tem­at­ic risk, mar­ket risk is the biggest risk an investor faces.

But what about “smart beta” or “fac­tor invest­ing”? These man­agers often present them­selves as a third way, com­bin­ing some active bets with inex­pen­sive, pas­sive invest­ing. Smart beta man­agers claim to be the best-of-both-worlds.

We at Swan Glob­al Invest­ments reject this line of think­ing. In our view, smart beta or fac­tor-based investors occu­py a spot on the same con­tin­u­um and are every bit as exposed to mar­ket risk as tra­di­tion­al active and pas­sive man­agers. If mar­kets sell off by 30%, 40%, 50% or more dur­ing a bear mar­ket, all man­agers on the spec­trum will be exposed.

Investing Methods Comparison | How Smart Is Smart Beta | Swan Blog | Swan Global Investments

History and Evolution of Smart Beta

To under­stand smart beta and fac­tor invest­ing, it is use­ful to under­stand its his­to­ry and evo­lu­tion.  Half a cen­tu­ry ago, peo­ple start­ed using the Cap­i­tal Asset Pric­ing Mod­el (CAPM) to explain how sen­si­tive an indi­vid­ual invest­ment was to move­ments in the mar­ket. The CAPM was the orig­i­nal fac­tor mod­el, and there was only one fac­tor: the mar­ket.

Variations on the Same Theme

Over the fol­low­ing decades, refine­ments were made to the orig­i­nal CAPM mod­el to cap­ture and quan­ti­fy addi­tion­al vari­ables. Eugene Fama and Ken­neth French deter­mined that small cap stocks and stocks with a val­ue tilt tend­ed to out­per­form over time. Fama and French added both these fac­tors to the orig­i­nal CAPM.

Dimen­sion­al Fund Advi­sors built their high­ly suc­cess­ful fund fam­i­ly upon these the­o­ries. Instead of pay­ing active man­agers hefty salaries to research com­pa­nies and assem­ble port­fo­lios, DFA instead sim­ply assigned “val­ue” and “small” scores to stocks, sort­ed them from high­est to low­est, and built their port­fo­lios around those bias­es.

Once the con­cept of fac­tor-based invest­ing and cheap com­put­ing pow­er became wide­ly avail­able 20 years ago, the flood­gates opened. There was a surge in quan­ti­ta­tive mon­ey man­agers, many using Barr Rosenberg’s Bar­ra Risk Fac­tor Analy­sis plat­form to con­struct port­fo­lios. A whole new breed of “quants” spent their days try­ing to iden­ti­fy new explana­to­ry fac­tors or design opti­miza­tion algo­rithms.

Smart Beta: All that Different?

This idea of fac­tor-based invest­ing even­tu­al­ly merged with the nascent exchange trad­ed fund indus­try to coa­lesce into the “smart beta” move­ment. The basic the­sis behind smart beta is that indices based sole­ly on mar­ket cap­i­tal­iza­tion are lack­ing. The idea is sys­tem­at­ic bias­es exist that would gen­er­ate excess rel­a­tive returns if these fac­tors were over- or under-weight­ed rel­a­tive to the cap-weight­ed mar­ket.

Every devi­a­tion from the orig­i­nal Cap­i­tal Asset Pric­ing Mod­el is some vari­a­tion on this basic premise. Fama-French, BARRA, fac­tor analy­sis, smart beta…it’s all vari­a­tions on the same theme.


All Way Stations on the Same Road

The main objec­tion Swan Glob­al Invest­ments has with all these strate­gies is that sys­tem­at­ic risk remains unad­dressed. In all of the CAPM-based mod­els, the biggest fac­tor is always sim­ple mar­ket risk. Mar­ket risk rep­re­sents absolute risk: the risk of cat­a­stroph­ic loss, the risk of run­ning out of mon­ey.

Of the 787 large cap mutu­al funds ana­lyzed, 746 had R-squareds of greater than 80% to the S&P 500. This means that for almost 95% of the large cap funds stud­ied, over 80% of their return pat­terns could be explained by move­ments in the S&P 500. Over two-thirds of the funds had R-squareds greater than 90%.

Clear­ly, the mar­ket is the pri­ma­ry dri­ver of returns for most large cap funds, regard­less if they are pas­sive, smart beta, or active.

We explore the devel­op­ment and impact of Smart Beta invest­ing in the white paper “Los­ing the For­est for the Trees.


About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.




Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com298-SGI-110117


By |2018-10-02T11:08:59+00:00November 2nd, 2017|Blog|Comments Off on How Smart Is Smart Beta?