Factor-based investing has become quite popular these days. Factors are characteristics of a group of stocks, the most famous being value and small cap, that are used to sort the overall universe of stocks. For quite some time, certain factors have been shown to outperform the overall market over extended periods of time. The finance industry has jumped all over this, and now offers many off-the-shelf funds and ETFs that aim to invest in these factors and outperform the market. There are about 400 Smart Beta funds now, totaling about $400 billion in assets. No need to do the work yourself. Just buy these simple off-the-shelf products and outperform the market. If only it were that simple. Today, I want to briefly touch on a fundamental issue with smart beta funds, how it impacts returns, and compare smart beta to doing factor investing yourself through quant strategies.
The big issue with smart beta ETFs is the structuring of the product for scale. Patrick O'Shaughnessy at The Investor's Field Guide has a must-read post on this topic. Basically, in order to make money off smart beta products, especially in the trend of lower fees across the industry, the finance industry needs to be able to scale these products to manage large amounts of dollars. The problem is that reduces returns. How much? Here's the key chart from the post.
Basically, the more stocks in the portfolio, the more cap weighting in the portfolio, the lower the returns. So much so that pretty soon, the fund is just a closet index fund. There are lot more gems in the post, but this is the main point. If you've read my blog for a bit, you know that there is a better way - doing your own factor investing through the quant strategies that I talk about here often. All of the strategies I've posted on are just ways to get exposure to the main factors that lead to market-beating returns. Let's see how one of those strategies does with various numbers of stocks and versus smart beta.
I used the Value 2 composite (VC2) quant strategy for this test, but with one small change. I limited the stock universe to the S&P 500 stocks versus the All Stock universe to get an apples-to-apples comparison. The results are better with the All Stock universe. I then varied the number of holdings from the basic 25 to 50 to 100. I also compared the results to the index, SPY, and the S&P 500 pure value index, which is basically a smart beta strategy. Backtests were run from the beginning of 1999 through yesterday. Below are the results:
Smart beta is pretty darn good. The S&P 500 value index outperformed the S&P 500 by about 1.5% over the last 17.25 years. But that is not even close to what a better more concentrated value approach achieved. Even a 100-stock VC2 strategy almost doubled the performance of the smart beta approach. And results go up for lower numbers of stocks, not to mention feasibility (fees, slippage, etc...) and ease of implementation. Almost of 600 basis points of alpha over a smart beta approach and 730 basis points over the index is definitely worth a little effort, I think.
In summary, quant stock investing far outperforms not only indexes, but also smart beta strategies. Of course, the doesn't mean it's easy, but it is certainly worth considering. In a future post, I'll talk about why investors should expect the outperformance of all factors and strategies to decrease in the future.