I’ve been meaning to do a longer, more educational piece for a while but sadly the joy’s of having an infant have given your author very little free time to sit and write. But I figured better to get something out and perhaps let the community fill in the blanks and oversights I missed. After introducing the concept of smart beta I will give some market based observations which may be of more interest to the typical MM reader who knows this stuff already, but I get the feeling there are many readers who are not full time finance professionals and would like some educational content. Anyways here goes.
Smart Beta, what is it?
The term beta, when applied to financial markets, usually describes a stock’s relationship with the overall stock market. This is usually expressed as “beta to the market” but could also be “oil beta” or beta to anything else. Wikipedia/Investopedia have a good theoretical and practical discussions of beta, but I am assuming most here have heard of the term.
Smart beta takes the concept of beta and augments it, saying there are many other “factors” out there besides the market that have a relationship with the movements of a stock. For instance, it is well documented by the god father of efficient markets, Eugene Fama, that company size and value are informative in determining a stock’s predicted return, though only after much obvious evidence was thrown at him. Anyways as most normal people expect, a stock’s future return is based on a number of factors, some of which are easy to explain and some of which are more idiosyncratic or company specific.
Popular factors include: Beta, Value, Price momentum, Quality, Growth and Volatility, but there can as many factors as you want, as long as you have the data. Quant funds typically play factors on a market neutral basis, meaning they rank all stocks on a factor, say earnings growth, and then to obtain the earnings growth risk premium by taking the top 20% of stocks less the lowest 20% (market neutral) and that result is called the factor premium, which is typically calculated on a monthly basis. If you have access to a Bloomy you can do this yourself with FTST, seen below:
While many quant shops determine a factor’s return on a market neutral basis (after adjusting for other factors and sometimes sector weightings) but on the flip side many “style” investors are long only a factor, including many actively managed mutual funds. If you own a “value” mutual fund, try and see if you can find a value index (Russell Value) and compare the two, especially as it relates to their outperformance vs the S&P 500. Often you will find that “value” funds tend to outperform at the same time. If this is the case, then you might want to re-think if your active manager is really providing much “alpha” or only beta to the Value factor.
Rise of ETFs, Quant Funds, Indexed Money
Listed above are just some of the secular trends that have embraced smart beta/factor investing and given their force in the markets I think its fair to say that factor investing is only going to increase, at least until there is a negative shock to disrupt those secular trends. Indeed many traditional stock pickers already complain of the rise of the machines and have been unable to adapt to the rise of this type of investing as its consequences have been far reaching.
Why should I care about smart beta and factor investing?
From the individual investor point of view, the rise of smart beta is very powerful as new factor ETF’s allow anyone to play the market from the angles the pro’s use. The problem is that smart beta investing is still very new to most investors and they may be unaware of how quick and big the moves can be when factor positions get over crowded.
For example, at the start of 2016 we had a climactic sell off in value stocks. Yes it was Oil and High yield that really led the market, but if you owned any value stock, chances are that it got killed as well, even if the oil or high yield exposure was not very obvious. Think QUALCOMM. Also financials tend to be the “value” sector because they often have the lowest PE ratios in an index, and they were also killed (but had obvious high yield and oil related exposures).
As oil prices bottomed, value stocks started to perform strongly. And post Brexit they were very strong, as global growth improved. Indeed the “value” factor often performs best at the early part of an economic cycle. Given that global growth was so slow heading into 2016, its no surprise that value started to outperform as growth bottomed. Market ping pong.
In the same way that some traders try to trade the business cycle with different sectors (buy cyclical sectors at the early part of a cycle and buy defensive non-cyclical towards the end of one) today’s traders can also implement the trade with “smart beta” or factor ETF’s if they choose to do so.
While trying to beat the market via sector timing or smart beta timing is no easier than trying to beat the market outright, there is still a lot of information investors can gain from seeing what factors performance is. We can see what is working in the market and try to generate a thesis for what the market is telling us. When value is outperforming along with cyclical sectors, its usually a good sign that we are still in the early stages of a business cycle rebound. When factors like quality or growth are outperforming, along with traditional non cyclical industries, it usually means that we are in the latter stage of a business cycle. To me these are the two biggest pieces of information you get.
Momentum, the dumb factor
For whatever reason, and there are many logical ones, momentum is a documented fact of financial markets. By simply looking at a stock’s price momentum (ie its price change over some historical period, usually 9M to a year) one can better estimate its future returns. Why a stocks historical returns should matter to its future, and how this effect can have existed for many many years is another discussion. But the fact that momentum is commonly used in markets is the main point I want to make. Indeed CTA’s base much of their models on momentum and lots of quant funds have it in their models because it works so darn well.
The problem with momentum is that it works until it doesn’t; as its prone to sharp reversals. Momentum trades tend to work like carry trades, they eat like birds, but shit like cows, as I read once.
Implications for Today’s markets
Current Factor Trends
As mentioned, post Feb and March lows in 2016, commodities, EM, high yield, small caps and value stocks all outperformed. This was a the typically play book trade at the start of a cyclical recovery, even though there was no recession and we were more than seven years into a bull market. As with all market moves, it ebbed and flowed, with commodities initially leading, along with high yield and then only later with financials after the Trump election. Still good with the cyclical play.
It is my view that many commodities are over bought, (though oil not so much, again a post for another day) and that the Chinese stimulus of 2016 along with their capacity reductions was the main reason for the uplift in most commodity prices to what are now unjustifiably high levels. Even if commodity prices don’t fall, I don’t think base commodities like Steel or Iron Ore will rise much from here. This is the first sign that the cyclical economic growth story is a short cycle. Small cap outperformance is also dubious given their high PE ratios and rising inflation and interest rates. They could outperform but I think the market is in a “show me” mode. Value stocks have already started to underperform generally, as seen below, though the trend is not very clear to me that they will underperform.
(PS anyone know of a good market neutral growth index? Anyways, Russell 1000 Growth Index is the big leader this year)
What I do think could be a catalyst for the markets is the financials. When the financial sector starts to underperform, because they start to miss earnings or Le Pen gets elected or just some other sector start to do better, there could be some serious selling pressure and knock the market off guard even if financials turn out to be a great buy at current prices for the next 2 years (I guess its possible, you never know). I feel like many financials are simply trading on momentum at this point. Enjoy it while it lasts.
The main point of this post has been to illuminate the role smart beta plays specifically in equity markets and try to explain to the novice financial market participant of what sort of things they should pay attention to. If all of this was new to you, then perhaps you will enjoy this little throw back as well.