‘Smart Beta’: Higher Returns, Higher Risk

November 8, 2013 Leave a comment

November 5, 2013, 3:10 P.M. ET

‘Smart Beta’: Higher Returns, Higher Risk

By Brendan Conway

“Smart beta” is the buzzword for a different type of stock indexing. Does it work? The strategists at Pavilion Global Markets this week argue yes. But there’s a catch. Smart beta or “fundamental” indexing means building stock portfolios around desirable attributes, such as profit margins, revenue, or dividends. PowerShares FTSE RAFI U.S. 1000 (PRF), a popular example, is something like value investing 2.0, since it’s usingquantitative methods essentially to hunt for attractive-looking stocks. It’s a shift from the S&P 500 (SPY), whose market-cap weighting method favors giants like Apple (AAPL) and ExxonMobil (XOM).Now here’s the catch: Investors may simply be swapping higher risk for higher returns.

Pavilion strategists Pierre Lapointe, Alex Bellefleur and Frances Donald ran the numbers on a range of monthly rebalanced smart-beta versions of the S&P since 1991.

Their finding: All the methods beat the no-frills S&P 500. But only one strategy — screening for stocks exhibiting low volatility over three months — beat the index with reduced risk.

“Every smart beta strategy we tested resulted in higher returns over 20 years,” the firm’s trio writes this week. “But it also came with higher volatility.”

Not coincidentally, “low volatility” ETFs are coming out of a mini-boom, one that has seen billions invested in PowerShares S&P 500 Low Volatility Portfolio (SPLV) and iShares MSCI USA Minimum Volatility ETF (USMV). Those two have turned in a strong 2013, but they’ve trailed the S&P 500′s 26% total return by a few percentage points (rising 21% and 23%, respectively).

On the other hand, there are lots of ways to slice the S&P 500 to find superior returns for a given time frame. For instance, just lop off the influence of giant stocks. Guggenheim S&P 500 Equal Weight ETF’s (RSP) 10-year annual return of 9.5% wallops the S&P 500′s 7.5%.

Besides the risk of a steeper selloff in bad times, keep an eye on when the high returns accumulate. Returns are often lumpy.

For the PowerShares PRF fund, most of the outperformance accrued during a small window during the stock-market recovery of 2009. Guggenheim’s ETF, too, soared 45% in 2009 (versus the S&P’s 26% rise), and has since held a more modest edge.

No matter for this niche’s enthusiasts, I guess. Smart-beta ETFs  have attracted some $45 billion in fresh money during 2013.

Filed under Macro Trends

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Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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