Beware of the siren of investment advertising
When is an advertisement misleading? “If you see Bitcoin on the side of a bus, it’s time to buy,” one of them recently read pasted on the side of a London double deck by Luno, a crypto trading platform. -change.
This is apparently not good: the UK’s Advertising Standards Authority banned it in May, saying it had not disclosed that bitcoin was complex, volatile and could put investors at risk.
I managed to resist Luno’s bus announcement. But five years ago, I was drawn to smart beta marketers. The experience has remained with me as a salutary lesson on the dangers of swallowing the more sophisticated marketing messages attached to new investment trends.
Whether such trends are more attractive to investors at the end of the bullish period is a matter of debate. But in 2016, having delayed adopting retirement savings following a career change, I felt like I was late for the party. A smart passive-to-beta style fund investing with a twist that promises to outperform market cap indices would help me make up lost ground.
And when the inevitable bear market arrived, it was argued, smart beta funds would weather the storm better than their market-capitalization cousins.
Unlike trends like Bitcoin or investing itself, this one had an intellectual pedigree. Academic studies, some of which date back to a century of performance, have revealed the factors or trends that smart beta funds exploit: Small-cap stocks outperform the larger ones, low-volatility stocks outperform those whose prices are rising, etc. Eugene Fama, a key promoter, won a share of the 2013 Nobel Prize in Economics for his research on smart beta, among other work.
Conquered by this academic credibility, I invested a good part of my pot in a fund with minimum volatility based on the S&P 500 American equity index, and I decided to check its progress again in 20 years.
Soon my resolve faltered. Sneak peeks last year revealed that the downside protection hoped for during the chaos of February and March was entirely absent: my fund fell faster and further than the S&P 500. Worse, it managed less than three-quarters of the gains made by the index. since.
I did some more research, checking out the things that I had missed.
I realized that, like most retail investors, what I owned was really just half a smart beta strategy. The academic evidence for factor performance comes from long-short portfolios, buying stocks that perform well on one factor and short selling those that perform poorly.
My ETF, like most smart beta funds available to retail investors, only used long positions. (I only found one fund that uses short positions, the baffling Amundi ETF Istoxx Europe multi-factor market neutral UCITS ETF). If the factors were the free stock market lunch, I might miss the main course.
Even the full meal, I quickly realized, might well be disappointing, as factors generally work less well after being discovered than before. According to a paper 2018 by Linnainmaa and Roberts, who focused on the factors identified in top academic journals, on average 58% of the outperformance was gone once they were identified and used by investors.
The picture worsened when I dug into periods of underperformance. The longest time my volatility factor underperformed its index was 16 years, according to Elroy Dimson, Paul Marsh and Mike Staunton, three financial historians who dug 121 years back using performance data for the five factors. The most common. They are mentioned in the Credit Suisse Global Investment Returns Yearbook 2021.
So I shifted the balance back to the dull world of market cap, choosing the cheapest S&P 500 based ETF I could find. Since then, I’ve been up a little, a gain of 5.8%, compared to 4.9% in my old low volatility fund.
Certainly, I am relieved, but I cannot tell you why this happened. This is the first problem with smart beta funds: Even academics can’t agree on why factors work or what happens when they don’t.
When my investment lags behind the indices, I need to understand why. As a market capitalization investor, I can: My pension goes up – or down – because, weighted by size, the top 500 U.S. companies on average do the same. But when factors underperform, no one can explain why.
This poses the second problem: no one can be sure that the factors will continue to work. From recent evidence, the value – the most famous factor of all – seems uncertain. If you had invested in US value at any point in the past 37 years, you would have underperformed the Market Cap Index – 37 years and counting is a string of losses.
Even if the factors continue to work in the future as they have in the past, the third problem is that smart beta funds may not capture them.
There is a big difference between the historical performance of a factor that combines long and short positions, and a smart beta fund, or the index it tracks, which are both only long.
This is one of the reasons why investors should be wary of back-testing – the popular process of advertising a new fund based on its past performance. A strategy based on buying tobacco stocks could have outperformed the index over the past 75 years, but you probably wouldn’t want to own it today.
The bottom line is that smart financial marketing doesn’t have to be deceptive, like Luno ads, to pose a risk. For me, the smart beta was the perfect pitch: understanding academic studies flattered my intelligence, and their simple rules were an antidote to active managers, whose great claims of competence and high fees had long made me suspicious. Sounding with my existing beliefs about investing, it sparked enthusiasm that allowed me to sidestep many pitfalls. An advertisement – whether on a London bus or gilded by the academic credibility of a Nobel Prize winner – should be as much a warning as an invitation.
Hugo Cox is a freelance journalist