Smart beta: a miracle disappoints

Yet again this week, we've been reminded that "smart beta" is not the miracle investment tool that the City might want us to think it is. Smart beta in effect, a fund that follows an automated "active" strategy rather than just entirely passively tracking an index has become increasingly popular, but new research from a company that developed some of the first smart-beta indices has warned the strategy could go "horribly wrong".

Smart beta involves creating and tracking indices based on factors other than traditional market capitalisation weighting, such as momentum (buying stuff that has already gone up), or value (buying stuff that's cheap). However, a recent report from smart-beta pioneer Research Affiliates has warned investors that there is a "reasonable probability" of a crash in the sector. The trouble is, those investing in smart beta seem to be buying based on recent performance rather than because they think a particular strategy has more potential than others.

This "performance chasing" is leading to dangerous overvaluation in certainareas, says Research Affiliates chairmanRob Arnott. Arnott and colleagues looked at the performance of popular smart-beta and factor-based strategies from 1967 to 2015.

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They concluded that the historical outperformance ("alpha") that made many of them so appealing was often simply due to rising valuations (underlying stocks in an index becoming more expensive) rather than a strong performance due to the strategy itself. This "alpha mirage" was, in other words, down to other investors having seen those stocks do well and buying them,rather than driven by any fundamentals.

The danger in buying overvalued strategies or sectors, says Michael Regan of Bloomberg, is that any correction back to "historical valuation norms" will come as a pretty nasty shock to investors who have previously profited from "swelling valuation ratios". Arnott sums up the situation neatly: "if you buy what has gone up just because it has gone up, you are buying for reasons that have nothing to do with valuations and run the risk of buying at the top of a bubble".

It's hardly ground-breaking stuff, but it's a useful reminder that if you are thinking of investing in smart-beta funds, then make sure you choose a strategy because it suits your investment goals and your asset allocation, rather than just because it has had a few good years. And as always, make sure there isn't a fund offering the same exposure at a cheaper price available from another provider.