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This is another of an occasional series on how good quantitative investors use both the left and right brains to create robust investment processes. Elisabeth Kashner at ETF.com wrote an intriguing series of blog posts about smart beta and factor funds. In Part 1, she showed that the idea of "smart beta" is mostly a marketing concept, where commonly used "dumb beta" ETFs have "smart beta" features:

Many of our favorite "dumb" funds, it turns out, have smart-beta features.

  • The SPDR SP 500 ETF (SPY | A-98) and the iShares Core SP 500 (IVV | A-98) both share an index that screens components for profitability, just like the index underlying the FlexShares Quality Dividend ETF (QDF | A-78) does.
  • The PowerShares QQQ (QQQ | A-53) has a tier of equally weighted securities, partially mimicking RSP, thus giving it a smart-beta tilt to small-cap stocks.
  • The iShares Russell 2000 ETF (IWM | A-82) accesses the small-cap premium-that's factor investing.
  • The iShares Russell 1000 Growth (IWF | A-89) has momentum exposure-that's also factor investing.

The surprises go the other way, too-"smart funds" have some pedestrian features. VIG, the smartest-seeming of the top 10 above, is cap-weighted. So, what happened to alternative weighting as a hallmark of smart beta?

In Part 4, she went on to discuss the idea of "factor exposure":

Designer funds promote the smart-beta label. However, branding all funds with factor exposure as smart beta will start arguments. In terms of our ground rules, sorting ETFs by factor exposure produces results that are not widely acceptable to the ETF community. If factor exposure defines smart beta, then all funds with factor exposure must be smart beta. As you will soon see, most funds have some kind of factor exposure.

Factor vs. smart beta investing
For non-quants, a factor is a way of ranking stocks. One simple example of a factor might be P/E, ranked from low to high. Kashner went on to demonstrate different flavors of value ETFs as a way of illustrating the factor investing idea. She demonstrates that there is really little difference between "smart beta" and factor investing:

Look carefully at the table below. Which better captures the value premium: VLUE or IWD?

(click to enlarge)

IWD beats VLUE with the lower P/B-the classic value metric. IWD also has the higher dividend yield. VLUE sports the lower P/E ratio. VLUE's correlation with IWD is 0.98, with a .99 beta. The two are largely indistinguishable, but if I had to pick a value fund, I'd go with IWD.

Security selection can produce powerful portfolio tilts, just as weighting can, because any security not in a portfolio has a weight of zero percent. If VLUE is a factor fund, then IWD is a factor fund.

Pitfalls of smart beta and factor investing
If "smart beta" is really another way of packaging active, or semi-active, factor investing, then you have to understand the pitfalls of the factor investing approach. The one valuable lesson I learned as a quantitative investor is that all factors do not necessarily work well across sectors and industries.

BARRA taught us that one of the ways of determining the sources of equity risk is industry exposure. If a portfolio tilts away from the market index (however you want to define it) with different industry exposures, then that portfolio has an active bet, or exposure. The above examples of value ETFs have differing industry bets that form part of their active exposure. If it is marketed as a passive or semi-passive portfolio, then the investor has to make a decision of whether those more or less permanent industry bets make sense as a way of creating alpha.

One drawback of naive factor investing is that practitioners are overly analytical, but have not subjected their ideas to practical sanity checks. For instance, some studies have shown that portfolio of stocks weighted by sales, rather than capitalization, have yielded better risk-adjusted returns. If you were to naively weight a portfolio of stocks by their sales, then you would tilt the portfolio towards companies with high sales and low margins. Do you want to necessarily bet that low-margin businesses, such as grocery chain stores, will outperform in the long run?

Even if you were to engage in industry-neutral factor investing by neutralizing the industry bets by setting the same industry exposure in the portfolio as the market portfolio, factors do not necessarily behave the same way across all industries. Let us suppose that you were to screen for low-PE stocks and overweight them in your portfolio. Low PE is a value factor, and it does not necessarily work well in growth industries. For example, did you really think that a growth-oriented technology stock like Google (NASDAQ:GOOG), (NASDAQ:GOOGL) would trade at 10 or 12 times earnings? If it were to trade at those kinds of multiples, would you really want to own it?

A so-called growth stock sporting a low PE is really a busted growth company with a turnaround story (whatever happened to PALM?), which encompasses a very different style of investing than the usual growth and momentum theme. For instance, see what Stan Druckenmiller thinks of Amazon.com (NASDAQ:AMZN) (stratospheric PE) compared to IBM (trailing PE 13).

Just remember that "Value works. Growth works. Momentum works. Quality works. They just don't all work at the same time." (see A quant lesson from a technician). To leave any of those factor sets out is to leave out part of the market and alpha generation opportunity set.

The moral of this story is, if you were to engage in factor investing, whether indirectly through "smart beta" concepts or directly in an active or semi-active fashion, you are making a deliberate bet against the market portfolio. Just make sure that your approach to factor investing is done in an intelligent way and it has not taken on any bets that don't pass human sanity checks. In other words, use both your left (analytical and reasoning) brain, as well as your right (creative and intuitive) brain to approach factor investing in an intelligent way.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Source: 'Did You Expect GOOG To Trade At A PE Of 10?' And Other 'Smart Beta' And Factor Investing Questions