If you pay any attention to the social sciences, you're probably aware of the "replicability" crisis the dawning realisation that many experiments once seen as definitive have turned out to be impossible to replicate, rendering the findings questionable or even invalid. Why is this relevant to investors? Because something similar is going on in the world of "smart beta".
The amount of money in smart-beta funds has trebled since 2012 and is set to hit $1trn worldwide by the end of 2017, says fund researcher Morningstar. The idea is that certain investment strategies consistently beat the market over time. By building an index that exploits these "factors", smart-beta funds claim to offer cheaper prices than active ones, but better performance than classic passives (which track indices weighted by market capitalisation).
Their popularity has triggered an academic gold rush, with more than 500 "factors" now proposed by some estimates. There's just one problem most of them don't work. Researchers led by Antti Suhonen, a finance professor at Aalto University in Finland, looked at 215 strategies across five asset classes. They found an average 73% deterioration in risk-adjusted returns between back-testing and live performance, says Attracta Mooney in the Financial Times. In other words, the strategies look great on paper, but fail miserably in practice.
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The issue is "data mining" tweaking a strategy against historic data until you find a variation that delivers great returns. As Peter Sleep of wealth manager Seven Investment Management tells Mooney, computers make it "easy to perform millions of back tests and find which one looks best to clients". In reality, you've quite possibly uncovered a one-off random correlation, rather than a repeating pattern; or you've found a strategy that works, but only in limited circumstances and using an impractically small (for a fund) amount of money.
Some well-researched "factors" have performed reliably over time (so far): value (buying cheap stocks), momentum (buying stocks that are rising) and small-caps (buying small stocks) are examples. But no strategy even one that works outperforms all the time. For example, value has underperfomed badly for over a decade now. It's yet another reason to take smart beta with a pinch of salt.
Fund groups like it because they can sell passive funds at premium prices with an exciting marketing story. But we'd suggest that if you really want to try to beat the market, go the whole hog and find a good active manager with a transparent, high-conviction strategy and low fees; or stick with investing in cheap markets with old-fashioned trackers at least you know what you're paying for.
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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