As ETFs and passive strategies continue their march into the lunch-rooms of the world’s biggest active managers they’re resorting to a series of rearguard actions. One of these getting a lot of press has been the concept of so-called ‘Smart Beta’ [Eeeew!].
If the term is new for you a smart-beta strategy is supposed to work something like this; automate stock selection to prefer certain styles that back-testing say is effective and voila! Automated active management. There’s just one problem with this superficially attractive strategy. There’s no evidence, save from the providers of these strategies, it actually works.
The paper highlighted this week is from the most recent edition of No Life Monthly AKA the Financial Analysts Journal and in it U-Wen Kok, CFA, Jason Ribando, CFA, and Richard Sloan from the investment firms of RS Investments, Victory Capital Management and the University of California respectively take a close look at a smart beta strategy that focuses on ‘value investing’ .
In theory this should be straightforward. Task your machine with finding cheap stocks, which is easy because they’re the ones with either a low P/E, P/B or both. Buy those and sell the expensive ones; genius. The paper analyzes in detail though why the strategy doesn’t work.
First, the expensive stocks located by the strategy tend to be small and therefore difficult to operate in in a real-world context. Second the ‘cheap’ stocks are, more often than not, cheap for good reason. They’re typically a) misstating book values which are subsequently written down, b) undergoing a cyclical earnings pop that reverts to a lower mean and c) stocks where future earnings’ forecasts are too high pumped up by an overly enthusiastic analyst community.
There’s a bigger point here. Everyone want’s a hack for investing; but, save hard work, experience and a ton of stock by stock due diligence I’ve yet to be convinced there is one. CAPM, VAR, smart beta and other snake-oil finance theories share common characteristics of on-the-surface sound theory and in many cases beautiful math; but, in the real world we observe they’re just plain wrong.
You can access the paper in full via this link Facts about Formulaic Value Investing.
Happy Sunday.