The myth of the smart beta crash

TETF Focus his week marked the 29th anniversary of Black Monday, the Oct. 19, 1987, stock market crash that saw the largest ever one-day percentage loss in the Dow Jones Industrial Average.

For those in the ETF industry, however, warnings of a different potential crash have been all-too common recently.

Earlier this year, no less an authority on the topic of Smart Beta ETFs than fundamental indexing creator Robert Arnott of Research Affiliates warned of a “Smart Beta crash” in the not too distant future.

Smart Beta ETFs try to exploit inefficiencies in the market associated with specific characteristics or “factors” — for example “value” or “volatility.” Instead of using market cap weightings to mirror an entire index, Smart Beta ETFs follow a different but pre-determined set of investing rules aim at capturing exposure to those sub-themes.

The argument for a crash goes something like this: With markets presumed efficient — at least over the long term — excessive fund flows into ETFs focusing on specific factors are bound to end in tears. Stocks fitting a given set of criteria risk will see indiscriminate inflows that stretch their valuations, skewing performance upward until the herds trample for the exits.

While any serious investor should be concerned about the possibility of such a development, it is also important to understand that narratives pinning the blame for potential future market mishaps on ETFs are nothing new. They are also often misguided.

So what does an ETF investor need to take into account?

First, for pure passive index investors, the immediate reaction to a crash warning is to lower exposure (in favour of cash, for instance). This is because the investment is seen to be on autopilot. If no one is in the cockpit, by doing “something” investors feel they are better served than by not taking any corrective measure.

For Smart Beta investors, the important distinction is the much greater level of activity of these ETFs. Individual stocks held by the ETF could at any point in time become overpriced, but holdings will be reset as the strategy’s “refresh button” is hit. The ETF will essentially reconstitute itself with a new batch of securities that better fits its investing rules.

For example: If a strategy seeks high dividend yielding stocks and some of the stocks in the category have seen their valuations stretched, the next application of the screens will point to others that have not been stretched.

Ditto momentum. If a stock’s momentum attributes deteriorate, momentum will be found in other names.

For all their growth, Smart Beta ETFs also remain a sliver of the aggregate pie as far as who controls the “sell trigger” on a given stock or factor. Others continue to pursue the same strategies outside of ETFs, which only serve to widen the access to such strategies.

Investors who are looking to explore Smart Beta ETFs should understand that not all factors work at all times, and their relative performance versus the market or each other may provide opportunities to fine tune one’s exposure to the category at different points in the cycle.

If you aren’t up to looking at implementing individual factors in your portfolio for fear of getting yourself into the wrong one at the wrong time, you could opt for a multi-factor strategy, which will give you exposure to several (such as value, momentum, quality and size), and use different weightings to adjust your exposure at different times.

Finally, factors are not always consistent across geographic regions, meaning you can also seek to diversify globally in the factor category of your choice.

The warning of a crash makes for great headlines, no doubt. But it’s more likely that we will see periods of underperformance for factors that had previously benefitted from excessive enthusiasm.

There is no doubt, for example, that the chase for yield has been fuelled by ZIRP worldwide. I wouldn’t expect a crash, but it would be wise in this case for investors to watch how the category fares if the Fed actually hikes rates in December. And remember that in Canada, rates may in fact be lowered, as opposed to raised. That means U.S. dividend and Canadian dividend ETFs won’t necessarily react in like fashion either.