Some experts are warning that smart beta returns might not be as good as some providers are forecasting © Dreamstime
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Whether you call it smart beta, strategic beta or factor investing, it has been one of the most popular investment strategies of recent years.

A hybrid between active and passive investment management, these funds take a passive strategy but modify it according to one or more factors, such as favouring cheaper stocks or screening them according to dividend payouts, in order to generate better returns.

However, some experts are warning that smart beta returns might not be as good as some providers are forecasting. Of particular concern to many analysts is the rigour with which smart beta factors are assessed via so-called back tests. The prevalence of data mining, in which performance data are tested until the desired result is achieved, is seen as a problem. Traditional funds, in contrast, tend to be back tested against established benchmarks.

“You have to be careful with the data back test,” says Hortense Bioy, director of passive fund research in Europe at data provider Morningstar, adding that there are many instances where a manager has been tempted to “tweak” the model to improve the results.

It is critical, she says, that the back tests are conducted to model for different market stresses, not just the most optimistic scenarios.

Concerns about back tests are justified, says Antti Suhonen, director of solutions at MJ Hudson-Allenbridge, the invest­ment adviser, and finance professor at Aalto University in Finland. “There is an element of data mining,” he says. “You don’t have established benchmarks and common terminology in this space.”

Even the strategy’s pioneers are asking questions. Rob Arnott is chief executive of Research Affiliates, which developed some of the world’s first smart beta indices. Last year, he warned that some products could go “horribly wrong”. He said the investment management industry “must make every effort to avoid being duped by historical returns”.

Eric Ervin, chief executive of Reality Shares, a San Diego-based research firm that offers three smart beta exchange traded funds, says there are some “heavily marketed back tests” that might not stand up to rigorous analysis.

In his previous role as a wealth manager, Mr Ervin says he could only really be satisfied that back tests were valid once he had run the numbers himself. “You have to ask yourself: ‘Does this strategy make sense?’” says Mr Ervin.

Reality Shares focuses on dividend growth strategies using a stock ranking methodology that assesses a company’s ability to grow dividends, based on elements such as free cash flow (the cash left after operational and capital expenditure) and historical earnings growth.

“From our side we are mindful of the dangers of data mining — a lot of due diligence goes in,” says Ana Harris, head of equity portfolio strategists, Emea at State Street Global Advisors.

She adds that conversations with investors interested in the products “can last for several years before the execution”, though in most cases growing understanding of smart beta, including more media coverage and company efforts at education, mean such long time frames are unusual.

As with any product there are risks. Ms Harris cites investors who got their fingers burnt after a rush to low-volatility strategies in 2009, triggered by the global financial crisis. Markets recovered more rapidly than anticipated, and low-volatility funds suffered.

From investors’ current standpoint it is easy to see the appeal of smart beta strategies. As regulators and research providers have questioned the value of the traditional stockpicking fund manager, investors have increasingly favoured a product that promises better returns and lower fees. Smart beta strategies typically charge higher fees than traditional index products but still cost less than actively managed funds.

Smart beta managers have been scooping up assets from their active counterparts. Assets under management in smart beta funds are on track to hit $1tn by the end of the year, according to FT analysis of Morningstar data. The strategy has been the fastest-growing section of asset management over the past five years. Multiple smart beta products have been launched in the past few months.

But as the strategies become more prevalent, industry figures predict smart beta products will grow in complexity. “We’re starting to see more appetite for more complex solutions,” says Ms Harris. Ms Bioy agrees: “Multi-factor products are definitely getting traction.” She cautions investors to proceed carefully and understand the strategy. “That is key.”

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