Most Smart Beta Funds Could Soon Look Dumb
February 29, 2016

Most Smart Beta Funds Could Soon Look Dumb

Wayne Gretzky was probably the greatest hockey player that the world has ever seen. Sixteen years after hanging up his stick, The Great One still holds or shares 61 National Hockey League (NHL) Records. One of his famous quotes is, “I skate to where the puck is going to be, not where it has been.”

That’s also a smart investing maxim. But many investors in Smart Beta Funds might be doing the opposite.

Most ordinary index funds track the market’s return. Such plain vanilla products weight their holdings based on each company’s respective size, measured by market capitalization. Take the S&P 500. Apple (AAPL) is the most valued company in the United States. So the iPhone maker is the most heavily weighted stock in a S&P 500 index, clocking in at 3.19 percent of index value.

Smart Beta funds–which are sometimes referred to as Factor Based funds–try to beat their benchmark indexes. Marketing literature says they do it easily. But no investment can beat the market if its components and weightings are the same as the market’s. That’s why Smart Beta funds don’t hold stocks in proportion to their market capitalization. Instead, their funds have different rules. One popular style is an equal weighted index. Apple’s emphasis in an equal weighted S&P 500 index would be equal to that of any other company in the S&P 500. An equal-weighted portfolio, by definition, will have a larger portion of its assets invested in relatively smaller-cap stocks. And instead of having a 3.19 percent index weight, Apple has a 0.2 percent weight. That’s 1/16th of its weight in the S&P 500 index.

Guggenheim’s S&P 500 Equal Weight ETF (RSP) is such a index. It costs 0.4 percent per year. That’s expensive for an ETF. But it has also crushed the returns of the S&P 500. Between its April 24, 2003 launch, and February 19, 2016, it gained a total of 184.67 percent. Vanguard’s S&P 500 Index gained 108.96 percent.

S&P 500 Index Funds
Traditional versus Equal Weighted
April 24, 2003-February 19, 2016

S&P 500 Index Funds
Source: Morningstar

Other Smart Beta index funds exist. They include Momentum Index Funds, which emphasize a greater weighting on stocks that are currently rising in price; Low Beta Index Funds, which have greater weightings in stocks that aren’t volatile; and Gross Profitability Index Funds that emphasize stocks with high levels of business profits relative to assets.

But their growing popularity could pose a problem. Investors are skating to where the puck has been. They’re chasing past performance. Here’s what happens. A fund company backtests a configuration of stocks for a new type of index. Promoters create charts and marketing materials that explain how such an index would have outscored its rivals. Investors rush in to the new style of index. But as its popularity increases, so do its stocks’ price to earnings ratios.

An equal weighted S&P 500 index, for example, has as much money invested in firms like Activision Blizzard (ATVI), Ball Corp (BLL) and Gilead Sciences (GILD) as it does in any of the bigger S&P 500 stocks. As such, the stocks of these less-known companies end up with higher PE ratios than they normally would have. Vanguard researchers Joseph Davis, Roger Aliaga-Diaz and Charles J. Thomas show that high PE ratios are bad for long-term future performance.

That could be why Vanguard’s traditional S&P 500 Index has beaten Guggenheim’s S&P 500 Equal Weight ETF (RSP) over the past five years. Vanguard’s traditional S&P 500 index gained 43.03 percent. Gugenheim’s equal weighted equivalent gained 41.12 percent.

S&P 500 Index Funds
Traditional versus Equal Weighted
February 19, 2011-February 19, 2016

S&P 500 Index Funds

Source: Morningstar

Research Affiliates’ Rob Arnott, Noah Beck, Vitali Kelesnik and John West say that Smart Beta or Factor Based funds could disappoint investors. They recently published, How Can “Smart Beta” Go Horribly Wrong? In it, they show that much of the past decade’s market-beating gains from such funds have come from rising valuations. Investors rushed into such funds because they had performed well. That raised the PE ratios of certain stocks to higher than normal levels.

Research Affiliates, however, says that not all Smart Beta funds are stuffed with overpriced stocks. For example, those with a higher weighting of value stocks could soon be scoring goals. Such stocks usually have low PE levels. But they aren’t currently popular. Compared to the rest of the market, value stocks are lower now than ever.

Below, you can see how several factor based models have become more expensive or less expensive, compared to the overall market over the past ten years. PE ratios for value stocks, for example, dropped 4.78 percent per year, compared to the overall market.

On the other hand, stocks in Smart Beta Momentum funds increased their PE ratios by 3.33 percent per year. Rising PE ratios aren’t sustainable. At some point, something has to give.

If you want to skate to where the puck will be, look at the factor styles that have seen their PE ratios drop, compared to the rest of the market. They include value indexes, small cap indexes, fundamental indexes and risk efficient indexes.

Annual Average Changes In Valuation Compared To The Overall Market
10 Years Ending Q3 2015

Index Factor Annual Valuation Increase or Decrease
Value -4.78%
Momentum +3.33%
Small Cap -0.36%
Illiquidity +2.85%
Low Beta +0.31%
Gross Profitability +4.15%
Equal Weight +0.21%
Fundamental -1.29%
Risk Efficient -1.53%
Low Volume +1.65%
Maximum Diversification +0.74%
Quality +0.56%

Smart investors shouldn’t follow lemming-like behavior. Instead, they should build a diversified portfolio of traditional index funds. They could also add an index that represents an unpopular investment style. As Wayne Gretzky says, if you don’t skate to where the puck has just been, it’s a lot easier to score.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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