Separating Reality From Catastrophe
By Roger Nusbaum, AdvisorShares ETF Strategist
WealthManagement.com posted an article titled Rob Arnott Says You’ll Be Sorry For Ignoring Smart Beta Warnings. Arnott notes that part of the outperformance broadly speaking has come from money flowing into these funds creating something of a self-fulfilling cycle. As a reminder, Arnott was very early to smart beta (or any of the other terms you like better), launching a four factor ETF in 2005.
In the article, there are several references to smart beta strategies “trading rich” which is obviously a valuation issue. He says price matters which is hard to disagree with. He gave one example about performance chasing where factors like low-volatility can become dangerously expensive. Indeed, they’re already down 12 percent since August, according to a Dow Jones U.S. market-neutral basket.
I am not sure what that means. The article is current so looking at six months of data, the S&P 500 is up a little over 7% and the two largest low volatility ETFs tracking large cap domestic equities (naming names is tricky for compliance reasons) were up a little over 1%. Clearly a lag but six months isn’t a long period of time. For five years, there’s a different story, the S&P 500 is up 72% and the two ETFs were up 64% and 70% respectively.
Arnott goes on to say he sees this performance chasing as a looming catastrophe for buyers. This seems very unlikely. The downside here is that a given strategy will lag the broad market for an extended period. Taking a very simplistic example between a large cap value strategy and the index, one must outperform and one must lag. There isn’t a scenario where, sticking with the word catastrophe, a value oriented smart beta goes down 40% while the S&P 500 goes up 10%. It would be easy to see that value oriented smart beta up 5% or flat in an up 10% world which isn’t catastrophic unless you have an inordinately low tolerance.
We have said before that if you’re going to pick one of these you have to stick with it as value, sticking with the same example, will most certainly rotate back into favor and outperform for some period and then the pendulum would swing back to growth and so on.
There is however a need to look through to a fund’s holdings and look for an obvious threat. One of the first low volatility funds started out with over 30% in utilities. The was called out by many media and blog outlets as being problematic if interest rates were ever to rise, utilities are interest rate sensitive. The process was changed and now the weighting to utilities is 23%. If you think that is too much and would cause too large of a lag for the fund when rates rise then you would look for another low volatility fund. If some other type of smart beta fund had 30% in Singapore then you would need to study up on Singapore and so on.
This niche is valid, after all market cap weighting is a factor, but there are risks even if down 40% in a down 10% world isn’t one of them.