Stefan Dunatov emphasises the importance of consistency between strategy, investment beliefs and implementation when exploiting techniques like smart beta
One of the perennial debates in economics and financial markets is around market efficiency. A related debate in recent years has been how to use ‘smart beta’ techniques to exploit the perceived inefficiencies discussed in these debates. My own view is that, at a micro-economic level, markets are broadly efficient. There may be varying degrees to this efficiency and the ability of markets to clear and the like but, by and large, markets tend to be either the best allocators of resources we have, or the best starting point for policy decisions.
At the macro-economic level, most markets also appear to perform sensibly, certainly where aggregation allows. But one of the oddities is financial markets: we recognise some truth in Samuelson’s famous remark that equity markets have predicted nine out of the last five recessions.
In particular, financial markets appear to exhibit excess volatility versus some sort of fair value (although it is not always obvious what this fair value should be). For instance, although the volatility of economic output has gradually fallen through time, the volatility of equity prices has not. Why do markets that appear to act efficiently at the micro-economic level (such as equities) appear to act inefficiently at the macro-economic level? And what can investors do, given this apparent excess volatility? Is this what might lead them to employ smart beta, for instance?
Taking the first question, explanations of excess financial market volatility should probably incorporate a mixture of fundamental metrics, an account of valuation changes based on where we might be in the business cycle, and behavioural economics. One interesting approach has been the use of ‘rational mistakes’ to explain price behaviour, as suggested by the work of Mordecai Kurz, whereby market participants are acknowledged to have no idea what the true long-term fair value of a security might be, but they can guess what this might be and collect information through time to assist in re-forming judgements. This approach combines rational agents, clearing markets, business cycles and agent behaviours (including mistakes) in a cohesive way that helps explain market volatility.
Markets are not excessively volatile, although the more ‘correct’ our guesses of fundamental values are and the more market participants can agree on them, the less exhibited volatility there may be. (I leave aside the issue of pricing model uncertainty here, where, although participants can agree on what the price may be, they are all, in fact, using the wrong model to come up with the price – as occurred in the sub-prime crisis. This in itself may drive volatility higher.)
From this starting point, what can investors do? First, focusing on long-term objectives and risk tolerances are essential to ensure the right investment strategy. The beliefs and characteristics of the investor are also important. This is why the discussion about market efficiency and volatility is relevant. A long-term investor should be disposed to taking advantage of the observation that market prices tend to fluctuate in cycles around mean-reverting long-term levels. A strategy of long-term, value-driven investing should then pay off where investors can ‘see through’ economic cycles or have some basis on which to judge what long-term fair values might be.
Second, asset allocation should also reflect the objectives, beliefs and tolerances of the investor. Asset allocation is not strategy per se, but the way in which the strategy is expressed. An example would be emerging markets (EMs): if an investor believes that the best way to capture emerging market growth is through direct ownership of local EM assets, the asset allocation should reflect the valuation changes associated with all assets that could fulfil that strategy. Therefore, switching from 100% EM equities to 100% EM bonds based on valuation changes would mean a change in asset allocation but no change in investment strategy.
This brings us to the topic of smart beta. Smart beta is a choice regarding the weighting system of various factors of, and rebalancing approach for, any investment portfolio. Just as asset allocation is a way of implementing asset strategy, so the smart-beta decision is a way of implementing asset allocation. In this sense, smart beta decisions are not investment strategy decisions, but they are important ways of ensuring that portfolio construction is better aligned to the beliefs of investors, and hence their investment strategy. The choice of smart beta from the number of alternative approaches should be clear given the beliefs, objectives and strategy of the investor.
In the framework described above smart beta cannot supplant the long-term, value-driven investment strategy, but it can be used to help fulfil it. Beliefs about market efficiencies should lead to well-thought-out investment strategy and smart beta may well be the correct implementation vehicle given those beliefs.
Stefan Dunatov is CIO at Coal Pension Trustee Services