Smart Beta: Broken by Design?
Investors Can’t Have Their Cake and Eat It Too
February 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Smart beta excess returns are different from factor returns
- The Low Volatility factor shows the highest discrepancy between theoretical and realized returns
- Investors might be better served by embracing long-short factor products
REALITY DYSFUNCTION
Steve Jobs’s “reality distortion field” warped Apple employees’ perception of what was technically possible. Though it led to many internal conflicts, it also drove Apple to create world-changing products like the iPhone.
Finance has reality distortion fields of its own: Providers help redefine investors’ expectations of what particular investment strategies can deliver. Smart beta has an especially strong reality distortion field. Academic research detailing the benefits of factor investing strategies has helped persuade investors to allocate more than $1 trillion to smart beta products.
But the scholarship motivating these allocations largely ignores transaction costs that reduce returns significantly. Furthermore, factor portfolios and smart beta products have different portfolio construction methods, so realized returns from investable products might differ considerably from the theoretical returns.
All of this begs the question: Is smart beta broken by design? (read Smart Beta or Smart Marketing)
THE RISE OF SCIENTIFIC INVESTING
Many scientists have been lured to Wall Street in recent decades. Often they join financial institutions and produce research papers showcasing the attractive risk-adjusted returns generated by innovative quantitative strategies.
Over time, these PhDs have produced a flood of papers on factor investing, which provides the theoretical foundation of smart beta allocations.
