What is Smart beta and Factor Investing?
Smart Beta is a rules based method to pick stocks that focuses on certain factors other than traditional market capitalization (i.e. size) weighting (which is what standard market tracking ETFs are based on).
Factor investing is a type of Smart Beta and refers to grouping investments based on a trait or characteristic. It has flooded the market and gained in popularity but has also confused investors.
Most of the attention is on the higher returns factors, but little attention is devoted to their risks and volatility, meaning investors could be unprepared for a bumpy performance ride.
Types of Investing Factors
MSCI1 identifies 7 main factors, and we have listed the ASX ETFs that have these bias/tilt.
|Factor||Characteristics||ASX ETFs – Australian Shares||ASX ETFs – Global Shares|
|Value||Inexpensive stocks with low prices relative to their fundamental value||QOZ||VVLU, QUS|
|Low Size||Smaller stocks based on market capitalization who tend to have higher growth rates||MVW, EX20, ISO, MVE, MVS, SSO, VSO||VISM, IJH, IJR|
|Momentum||Strong past performance||N/A||N/A|
|Low Volatility||Stocks who do not react wildly to share market movements and are more defensive||MVOL, AUST||WRLD, WVOL, VMIN|
|High Yield||Paying high dividend yields for income focused investors||ZYAU, IHD, RDV, SYI, DIV, FDIV, VHY||INCM, WDIV|
|Quality||Demonstrating stable earnings growth, profitability, strong balance sheets, and low levels of debt||ETF||QLTY, QUAL, QHAL|
|Multi-factor||Combines numerous factors into one tradeable index||AUMF||WDMF, QMIX, ZYUS|
Factor investing is another form of active investing, and the performance of these factors are difficult to predict, meaning performance will be inconsistent.
No single factor can work all the time, as returns tend to be cyclical. Factors come in and out of favour. Like any “active” strategy, timing of factors is extremely difficult to predict on a consistent basis. This is demonstrated in the next chart.
Backtesting is a method for identifying how certain strategies would have done based on actual results rather than forecasts, discovering how it would play out using historical data.
Attractive characteristics in backtesting are often based on data mining, which results in far less attractive performance once the product is available for the public to invest in.
Data mining involves finding spurious relationships in the otherwise random data. Translation – things can look good purely by luck. Voila! Think of an index like a deck of cards.
Backtesting lets you shuffle a deck of cards thousands of times until a favourable “shuffle” emerges to match the order you want to show.
Investors should remember correlation does not always equal causation. There is also a premium to pay for smart beta products as factors requiring higher turnover tend to have prohibitively high transaction costs.
Despite more and more factors being “discovered” every year, we continue to prefer broad market cap index investing. While factors can go through periods of outperformance, we believe that boring investing is brilliant.
If you’re considering investing in an smart beta ETF, it’s important to understand that you are actually taking bets on certain market factors beating others. You should be comfortable with what those factor bets are, and why you’re taking them.
Smart beta ETFs may be classified as passive (given it follows a rules based framework), but differs from plain beta (i.e. market cap weighting) due to it’s passively active nature of tilting towards a factor in order to try and outperform the market.
If you don’t understand the bets you’re taking and the only reason you’re investing in smart beta is backtesting or recent performance, then what you’re buying into isn’t smart beta as much as it’s smart marketing, and that’s not smart investing.
We continue to support research2 which concludes the approach of staying disciplined, sticking to a diversified portfolio of uncorrelated factors and assets, and holding for the long term instead of trying to actively time them.
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1 MSCI: Introducing MSCI Factor Indexes (2018)
2 AQR Capital: Contrarian Factor Timing is Deceptively Difficult (2017)