Rising risk with 'dumb ideas' masquerading as smart beta: Rob Arnott
One of the pioneers of unconventional portfolio strategies and smart-beta investing, Rob Arnott, has said there are a lot of “dumb ideas” masquerading as smart beta, which poses a risk to the sector. Arnott’s main concern is that the popularity of smart-beta ETFs has lead to inflated valuations which could result in significant losses for retail investors if the market unravels suddenly, adding that when there is a lot of complexity and little understanding, corrections can be sharp and painful.

Steadily increasing flows into popular exchange-traded funds referred to as smart beta are likely sowing the seeds of a future crash that could besmirch the investment strategy’s good name, according to Rob Arnott, chairman and chief executive of Research Affiliates.

Arnott should know. He is widely regarded as one of the founders of the smart-beta strategy. But now he’s lamenting that the smart-beta moniker has been dangerously stretched, in his opinion.

Smart beta is a twist on the typical index fund. But unlike passive-index funds, such as the SPDR S&P 500 ETF Trust SPY, +0.37% , that are weighed by market capitalization, smart-beta funds weight stocks according to a variety of traits, such as price, volatility, value or momentum. In recent years, the number of traits, or factors, has ballooned.

“There are a lot of dumb ideas now masquerading as smart beta. My fear is that a potential crash that we hypothesized—in a few overvalued ‘smart beta’ strategies—may make the ‘smart beta’ label a subject of future jokes, and a chapter in the [Chartered Financial Analyst] program,” Arnott told MarketWatch via email. (The CFA program confers one of the most coveted designations for Wall Street professionals, focused on the intricacies of financial markets.)

Smart beta was popularized by the rise of exchange-traded products that have made it easier to invest at a lower cost than active managers typically charge for the same portfolios.

Back in February, Arnott raised eyebrows when he published a white paper questioning the soaring popularity of smart-beta strategies that sent valuations of such funds to new heights.

“Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive,” Arnott wrote, warning that the soaring popularity of such strategies leaves a “reasonable probability of a smart-beta crash.” Read Arnott’s paper here.

Flows

Smart-beta ETFs have enjoyed record inflows over the past year.

The vast majority of new ETFs launched in 2016 have been smart-beta products, which have attracted record flows, so far in 2016, according to ETFGI, an industry research firm.

Year to date, smart-beta products have seen net inflows of $16.15 billion. ETFs designed to minimize volatility, often referred to as low-volatility ETFs, gathered the largest net inflows with $14.32 billion, followed by those based on value stocks with $6.83 billion, and dividend-oriented products with $3.09 billion, according to ETFGI.

Overall, through the end of June 2016, smart-beta equity ETFs and ETPs rose 7.1% to $429 billion from $400 billion, ETFGI said.

Arnott said the asset-management community is encouraging a hunt for returns to compensate for flat or meager yields which have prevailed in the broader markets over the past 18 months.

Arnott’s central concern is that the popularity of these smart-beta strategies have led to lofty valuations that could result in ugly losses for average investors, if the market suddenly unravels.

“If valuations were to revert back to their historical levels, these recently popular strategies can bring terrible performance,” Arnott said. “Also in my experience, when there is a lot of complexity and very little understanding on the part of market participants involved, the correction may be sharp and painful,” he said.

Read:Investors can bet on whether people will get fit, fat, or old with these ETFs

Performance

Among smart-beta ETFs, low-volatility and high-dividend funds rank as the top performers over the past 12 months, by far beating the traditional capitalization weighted indexes such as the S&P 500 SPX, +0.43% .

The two most-widely used low-volatility ETFs, iShares Edge MSCI Min Vol USA USMV, +0.15% and PowerShares S&P 500 Low Volatility Portfolio SPLV, -0.24% are both up about 11% over the past 12 months.

Read:Tough sailing: The case against buying low-volatility ETFs

As of Wednesday, The Vanguard Dividend Appreciation ETF VIG, +0.29% is up 6.3% over the past 12 months, compared with a 3.4% gain for the S&P 500 over the same period.

Cullen Roche, founder of Orcam Financial Group LLC, said investing in smart-beta ETFs at this point is performance chasing.

“When people chase performance they are chasing risk,” Roche said.

Read:Index fan Burton Malkiel takes on ‘smart beta’

Getting defensive

Both low-volatility and high-dividend strategies have holdings concentrated in so-called defensive sectors such as utilities, telecom and consumer staples. They’re considered defensive because companies in those sectors are expected to weather recessions or sluggish economic growth better than companies whose fortunes wax and wane in line with the economic cycle.

“Record flows and popularity of low-volatility funds have driven their valuations sharply higher, increasing their risk,” said Paul Bouchey, chief investment officer at Parametric.

“If your portfolio’s P/E rose to above historic levels, then it’s no longer defensive,” Bouchey said.

Indeed, valuations of defensive stocks such as utilities, consumer-staples and telecom companies have risen to levels not seen since 2007, after double-digit gains over the past year.

Read: Beware, this might be world’s most crowded trade

Some analysts are worried that accelerating economic growth, as well as higher interest rates, would hit sectors perceived as defensive, a prospect that Bouchey says would result in smart-beta fund underperformance.

“Smart beta will at some point underperform and when it does, people will start selling smart-beta ETFs,” Bouchey said, referring to investors.

Still, defensive sectors that promise dividends have become a place to hide in an environment of sideways trading and ultralow bond yields.

Roche considers the current environment of low yields and tepid economic growth as ripe for fostering a stock-market bubble.

“This market reminds me of a late-cycle market of the late 1990s,” Roche said.

The S&P 500 is trading at 17 times forward non-GAAP earnings, which is well above the 10-year average of 14.3, according to FactSet. The price-to-earnings ratio of the iShares Edge MSCI Min Vol USA, USMV, +0.15% which has a high concentration of financials, consumer-staples and health-care stocks, is 25.4. Valuations in both cases rose thanks to a rise in the prices while earnings growth declined.

Arnott cautions investors to stay away from newly overpriced “smart beta” strategies, that are seeing massive inflows, because “they’ve become expensive, creating an illusion of huge alpha.”

“A contrarian approach, avoiding recently expensive and favoring recently cheap strategies, may be uncomfortable in the short run; in the long run it is a sound way to take home reasonable performance,” he said

To be truly defensive in this environment, investors should be diversified in alternatives, commodities and certain bonds, according to Roche.

For those who are enchanted with recent stellar performance of smart-beta funds, Roche warns that relatively higher fees would eat into any future returns.

“Over the long term, an average investor will do much better with a cap-weighted index that has guaranteed low fees, than a higher-cost fund that only promises better returns, but charges high fees, as smart-beta funds do,” Roche said.