There is very little to prove that factor-based ‘smart beta’ strategies actually outperform on a consistent basis, according to robo-adviser Stockspot.
In its fourth annual report on the Australian ETF landscape, the online adviser and fund manager said that factors were “actually very hard to predict” and likened investing in smart beta strategies to taking a gamble.
“Smart beta is essentially taking a bet that a few select factors are more important than an all-factor (market value) approach.”
The report stated that evidence of smart beta strategy outperformance only came out of “backtesting over a select, historical time period which introduces a few significant issues”.
If an index could be thought of as a deck of cards, backtesting was effectively “shuffl[ing] a deck of cards thousands of times” until a shuffle that matched what you were looking for came through.
“But there’s no guarantee that the same strategy will work going forward. As a result, many smart beta strategies could have simply worked in the past by chance,” the report said.
It argued that smart beta strategies tended to follow “in-vogue style trends” as ETF product manufacturers understood that it would be easier to sell strategies that have recently performed well.
For example, several smart beta ETFs launched in the last few years have been dividend investment-focused off the back of high performance of dividend-based strategies in the years between 2011 and 2014, according to the report.
Citing research from Research Affiliates, the Stockspot report said: “On average, new funds launch about six months after the peak in their particular strategy compared to the broad index.
“This is not a coincidence – the product teams launching new funds usually take about six months to get them launched, so when they decide to launch a fund, it is usually at exactly the point that the particular strategy is showing its best results compared to benchmarks.
“Unfortunately, outperformance tends to end soon after smart beta ETFs are launched.”
In the last year alone, smart beta ETFs have demonstrated “mixed performances”.
While small and mid-cap smart beta ETFs outperformed the market, dividend and value-focused ETFs did “poorly, generally with negative returns”, and ethical ETFs provided “slightly positive” returns but still underperformed the broader market.
“Most smart beta strategies don’t hold up to any analytical rigour as tools for outperformance – typically, they pick a factor that has performed well in recent history and launch at the peak of that factor’s relative performance,” the report added.
“If you don’t understand the bets you are taking and the only reason you are investing in smart beta is backtesting or recent performance, then what you’re buying into isn’t smart beta as much as it is smart marketing, and that is not smart investing.”