Smart Beta is the Old Value

Smart Beta is the Old Value

If you’re a wealth manger or advisor, one of the toughest things to do is to get your clients to stay in the stock market during stormy times. August’s swoon and the recent market volatility have, of course, tested this time-honored advice.

After the 2008 crash, the exchange-traded fund (ETF) industry came up with a raft of new products designed to keep investors in stocks by offering them a lower-risk option. Hundreds of “smart” or “strategic” beta funds washed up on advisors’ shores. They featured stocks that were less volatile than those found in the average cap-weighted index, and used indexes based on a bevy of different factors—some well-known, like value, size or momentum, and others more dubious.

But were many strategic beta products really just value-oriented funds with a shiny, new wrapper and sales pitch? After all, many bargain-priced, out-of-favor stocks often fall into the strategic beta value camp, as they should. They are rarely glamorous, high-flyingh tech or biotech stocks.

According to Jason Hsu with Research Affiliates, a fundamental indexing shop, investors would be better served by sticking with a pure value fund, which is at the core of many smart beta products. But to reap a return premium that value offers, investors would have to stay in the course in the bargain-priced strategy, rather than to repeat consistent bad behavior and time the market. 

Of course, value investing is old hat, even in the burgeoning ETF market. Yet bargain-oriented stock fund managers fall prey to what ails most active investors: They buy high and sell low.

This persistent timing error triggers routinely sub-par returns for most active investors. According to Dalbar Associates, these wrong-headed investors have averaged a 5% annual average return over the past 20 years, compared to about 10% for the S&P 500 index.

“Underperformance is due to trend chasing,” notes Hsu, who showed that money flows into value funds goes up when immediate past returns are high and exits when the funds decline. Since value managers should be doing the opposite, individual investors are constantly going in the wrong direction.

If investors were simply to stay put during both up and down cycles, as might be accomplished in a value-oriented fundamental index ETF, Hsu says they would reap a 2 percentage-point bonus return over a plain-vanilla S&P fund. The value-tilt is a contrarian one, adding underpriced stocks when others are selling, and selling when others are buying.

From 1993 through 2014, Hsu found that value managers reaped a 9.36% net dollar-weighted annual average return, compared to about 9% for the S&P 500. This “value” premium, however, is unlikely to be earned by most market timers, who bail out of value funds precisely when they are picking up bargains.

The performance gap for those chasing returns appears across every investing style category, Hsu adds, and is most pronounced for growth stock investors, who lag the index by 3 percentage points on average.

“Performance-chasing value investors don’t make money,” says Hsu. “A contrarian approach to value investing is likely to succeed.”

So if investors are consistently doing the wrong thing at the wrong time, how is the cycle broken? Hsu suggested that routine fund ratings that give funds high marks for recent strong performance are often at fault. As any fund company routinely warns investors, past performance may not lead to future returns.

Hsu’s best advice is to reboot your clients’ approach to investing. “Try to be on the other side of the trade. Do the opposite of what the average investor is doing.”

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