Combining Smart Beta Funds May Not Be Smart
What happens if you add positive and negative exposures to the same factors?
August 2024. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Smart beta funds offer diverse factor exposures
- When combined in a portfolio these exposures often net themselves off
- As a result, investors are left with an expensive plain beta portfolio
INTRODUCTION
In June 2024 J.P. Morgan highlighted that their strategic allocation model included an allocation to a global value and a global technology fund. For investors versed in factor investing this likely led to mental red flags going up.
Value stocks trade at low valuations as these represent companies or industries in trouble, which is typically reflected in declining sales or earnings. In contrast, technology companies trade at premium valuations and exhibit strong growth prospects. Naturally, this implies that adding a value and technology fund is the equivalent of adding hot and cold water.
Unfortunately, we frequently observe investors selecting funds with opposing factor exposures and deriving portfolios with unintended consequences.
In this research article, we will highlight the risks of combining smart beta funds.
SMART BETA & BOND PORTFOLIO
Factor investing seems like the only path to achieve outperformance based on academic research. Implementation has become easy given hundreds of smart beta products that offer investors factor exposures via low-cost ETFs.
However, this evolution has largely taken place in the equities space where U.S. smart beta products manage close to $1 trillion, while the assets under management in fixed income smart beta products are less than $5 billion, which is a rounding error considering the trillions invested in fixed income mutual funds (read Smart Beta Fixed Income ETFs).
Given this, we will construct a portfolio using smart beta ETFs for equities but plain beta for fixed income. Specifically, we allocate 60% to four smart beta ETFs providing exposure to momentum, value, low volatility, and quality, and 40% to the U.S. Aggregate Bond Index.
