Smart-beta popularity reminiscent of value investing mistakes – Cambridge
Institutional investors are making many of their investment decisions chasing ideas that are unsuitable for them and reflect past return trends, according to Cambridge Associates.
The consultancy’s global head of pensions practice, David Druley, said this kind of attitude could once again be seen in the growth of smart-beta strategies in Europe, the UK and the US.
Smart beta – the term used to describe equity or fixed income investing that follows a systematic, rules-based strategy to achieve exposure to beta factors – has been growing in popularity.
Research from asset manager State Street Global Advisors suggested 40% of institutional investors across the US and Europe already allocate to smart beta strategies, while a further one-quarter are thinking to make allocations.
Further data from intelligence provider Spence Johnson has estimated European funds will have around €211bn in smart-beta allocations by 2018.
Durley, while acknowledging the effectiveness of some smart-beta strategies, warned that a rush of capital into these strategies would immediately make them more expensive and produce lower returns, two of the decisive factors when investors allocate capital.
“If enough people put significant amounts of money into various smart-beta strategies, it can very quickly become overvalued beta,” Druley said.
“Therefore, it will likely neither be lower risk nor generate higher returns, which is what these strategies are promising.
“How many of the strategies are really smart beta? And how many are just differing factor bets such as an overweight to small and mid-cap stocks, or low-beta stocks or to quality stocks?”
He said the rush of capital to the strategy was simply another example of investors chasing lost returns and evaporated ideas, not unlike pension funds moving to a value overweight after the market crash ended in 2003.
In the 2000-03 bear market, institutions became convinced value strategies carried less risk because they protected capital well as tech stocks burst, significantly affecting pension funds riding the equity wave.
The funds believed these strategies would outperform the market because they had done so over longer periods of time.
However, it was more down to the strategy being under-owned, and subsequently undervalued, before the crash, Druley said.
By the time the next next crash came in 2007, pension funds had allocated large sums to value strategies, believing the investment style would help protect capital in the long-run.
However, during the last downturn, value strategies in some cases lost more than other investments, according to Druley.
He said this was due to many of the component investments being financial stocks, which were also undervalued during and after the 2003 crash.
“Value strategies did worse than the market, in some cases dramatically,” Druley said.
“The cheapest-looking stocks were in many cases financials that got hit the hardest, and other value stocks weren’t unusually cheap.
“We saw how surprised everyone was in the last financial crisis that value didn’t offer great protection from the bear market. A similar thing is likely to happen again in the future. We are always fighting the last war.”