Traders work on the floor of the New York Stock Exchange (NYSE) on October 25, 2021 in New York City
Low volatility, small capitalisation and momentum strategies have underperformed in the US © Getty Images

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The “smart” in smart beta is supposed to refer to a more intelligent way of investing in markets. But an objective observer might assume it refers to the fact that the concept’s adherents are smarting from the pain of yet another beating at the hands of Mr Market.

Smart beta, also known as factor investing, is based on evidence that, historically, portfolios skewed towards certain stockpicking factors — such as value, quality, momentum, small size and low volatility — have outperformed the market over the economic cycle.

Of late, however, that tendency has broken down, and the travails of value stocks — those trading on lower price-to-earnings or price-to-book-multiples than their growth counterparts — has been well documented.

Since the market low of March 2009, after the global financial crisis, the US Russell 1000 Value Index has recorded annualised returns of 15.3 per cent, versus 18 per cent for the S&P 500. And, globally, the MSCI All Country World Index Value Index has shown 12.4 per cent returns, below the 14.6 per cent of its parent benchmark, according to Research Affiliates, a factor investing pioneer.

While these differences may appear small, they compound painfully over the course of a dozen years.

Low volatility, small capitalisation and momentum strategies have also underperformed in the US, although quality — stocks with a high return on equity, stable earnings growth and low leverage — has done better.

Performance has been a little more promising globally, with momentum and small-cap joining quality in outperforming broader index measures, although minimum volatility strategies, alongside value, have undershot.

Overall, then, it has been hard to make a case that factor premia have been evident since the 2008 crisis. Yet Vitali Kalesnik, director of research in Europe at Research Affiliates, remains phlegmatic.

“What we see at the moment is not unusual,” he argues. “There is no magic bullet for investors. [Factor] returns come at a risk. The risks are that you are going to experience a sharp drawdown and sometimes prolonged periods of underperformance.

“Investors underappreciate the risks associated with factor investing, but what we have seen [since 2008] is not outside what we saw before.”

In particular, Kalesnik says the historic data suggest that factor returns are often correlated — with value, small-cap and quality tending to rise or fall in tandem, “so, in a way, [the current situation] is not surprising”.

Moreover, Kalesnik says investors need to be wary of the danger of factors pushing up valuations to unsustainable levels. He believes this may have occurred to minimum volatility stocks in 2016, which “helps explain the underperformance since”.

The obverse may now be true for most factor strategies, with data from Research Associates suggesting they all now trade on relative valuations that range from medium to cheap by historic standards.

This is particularly so for value stocks. In September 2020, value was trading at its largest discount to the market, according to Research Associates. A bout of optimism triggered by the impending rollout of Covid-19 vaccines heralded a partial rebound. Even so, value’s relative valuation has merely risen to the midpoint between the all-time low and the nadir it touched during the dotcom boom, Kalesnik says.

Vincent Deluard, global macro strategist at brokerage StoneX — who launched one of the first smart beta exchange traded funds but now proposes a “dumb beta” fund that underweights stocks over-represented in smart beta portfolios — says value has underperformed for three reasons.

First, the value factor is cyclical, driven by economic trends such as inflation and interest rates. “It has a short duration bias, high cash flow and low price-to-book. When you have rates and inflation falling, value underperforms,” says Deluard — although he believes the world is “transitioning away from that macroeconomic environment”, which should aid value.

Second, the market anomalies that drive some smart beta strategies may have been arbitraged away. “If you can make money simply by owning stocks ranked by price-to-book or price-to-earnings, the market would be very inefficient. If all you had to do to beat the market by 3 per cent a year was to buy small stocks, people would figure that out quickly,” he notes.

Third, he argues the value factor was designed for the age of industrial companies “where you can value something you can touch and build”, such as a factory or railroad. Now, the value of, say, large technology or luxury goods companies “is in intangible assets that don’t show up on the balance sheet”, distorting book values.

Other strategies have been undermined by the US bull market having been led by the tech giants, which are underweighted in all smart beta strategies bar momentum, Deluard says.

Nevertheless, he expects a degree of mean reversion over the next 10-15 years, which would help underperforming factor strategies, with rising interest rates likely to hurt long duration tech stocks.

However, in a stagflationary environment, Deluard fears losses across the board. “It just means that value will perform just a little bit less badly than other things.”

Alan Miller, chief investment officer of wealth manager SCM Direct, believes smart beta still has a role. But he says investors need to be “selective” in choosing the specific factors and markets “in which the deviation from the norm is at its greatest,” and the expected returns are therefore highest.

That points to the value factor, he says, particularly with “growth” tech stocks now being so richly priced.  

Kalesnik concurs, arguing “a big chunk of the economy is significantly undervalued”, even as some tech stocks enjoy “exuberant” valuations.

He does not believe these valuation differentials can continue diverging indefinitely. “It can’t go on forever. Prices should have some connection to fundamentals,” he says.

“One of the key mistakes that investors make is being countercyclical. They tend to buy at high valuations. Factors like value are cheap, so it’s a great opportunity to buy.”

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