A Research Affiliates Smart Beta Investor…
When investors understand the investment philosophy, construction process, and return drivers around a strategy, they are more likely to understand why it may underperform over part of a market cycle. The transparent, rules-based nature of smart beta is simple to understand. In contrast, a multi-factor approach may be appealing when its performance is good, but easy to give up on when complexity makes understanding its poor performance quite difficult.
Mean reversion is unreliably reliable and, as such, demands a patient investor. Prices revert to “normal” valuations at varying paces and over fluctuating time frames. When markets do return stocks to more normal valuations, the valuation may be the stock’s historical mean or a completely different level. Investors who commit to a smart beta strategy should do so with a 10-year horizon, and memorialize their rationale for future decision makers.
Understands the impact of current valuations
Rising valuations, above their historical normal levels, can artificially inflate past performance and reduce the future return prospects of a smart beta strategy. Higher valuations create an added risk of mean reversion down to historical valuation norms, threatening an abrupt reversal of past performance. An investor must look “under the hood” to understand how a strategy produces its alpha. Value-added can be structural—a plausible source of future alpha. Or it can be situational—a consequence of rising enthusiasm for, and valuation of, the selected strategy. Netting out the effect of changing valuations on past returns results in a more reliable estimate of a strategy’s true alpha-producing ability.
Can live with the ups and downs of contrarian investing
The fundamental index approach rebalances by selling winners and buying losers, a quintessentially contrarian exercise, also the wise council of the father of security analysis, Benjamin Graham. Investors considering this strategy need to be honest with themselves about their ability to persevere during periods of underperformance while they await the market’s recognition that their portfolio’s undervalued securities are indeed undervalued, and the market’s subsequent shift to value them consistent with their true underlying fundamentals. For most investors, a contrarian strategy is a diversifying strategy, selected as one strategy among several in their portfolio.
But smart beta is not every investor’s cup of tea…
Obviously not every investor is a smart beta investor. For those who prefer to own the broad market, to pay next to nothing for market exposure, and do not want to play a performance-seeking game, a cap-weighted index strategy is a sensible choice. The market is not always efficient, however, and a cap-weighted index can assume disproportionately heavy concentrations in companies likely to be overvalued and light allocations in companies undervalued relative to their fundamentals.