A- A A+

Layer upon layer upon layer ...

David James |  16 March 2015  |  Portfolio

LayerOne of the latest, and disturbing, trends in the financial markets is the push to find 'smart-beta'. To explain, 'alpha' is the average market return, whcih in the share market is usually very good over time. 'Beta" is an additional return above that average. This is what fund managers pursue, and there is almost no evidence that they are able to achieve it. If they succeed in beating the market in one year, then they will almost inevitably fall below the average in the next year. Worse, the more they charge for their services, the more they will fall below the average market return.

Now, companies are trying to use algorithms to achieve beta. There are almost 400 smart-beta funds in the U.S. right now, and they account for $400 billion, or 20 percent of all assets, in domestic ETFs, according to Bloomberg Intelligence. That’s up from zero in May 2000, when the first prototypes—one iShares ETF aimed at growth and another at value—marched out of the lab and onto exchanges.

An article on smart beta describes what is going on:

"Like any Wall Street bonanza, this one has drawn imitators, innovators, and possibly a few hucksters, according to the U.S. Financial Industry Regulatory Authority, which included smart beta on a list of eight product categories that it plans to scrutinize for sales violations this year. “For individual investors, products tracking these indices may be complex or unfamiliar,’’ Finra said in a Jan. 6 letter. “It remains an open question how the indices and products tracking them will behave in different market environments.’’

No one has claimed credit for coining the now ubiquitous term smart beta, which, in just two words, makes a big, market-beating promise. Among the financerati, beta means return you get simply for taking the risk of owning stocks. The much rarer alpha is extra return from spotting something that the market missed. Despite what human managers say, alpha is rare. Smart-beta enthusiasts accept that and try to better mine the returns from beta using an eclectic range of strategies, filtered for various factors and united by their set-it-and-forget-it rule books."

 

The use of index funds (ETFs) is growing sharply. There are now $2 trillion in assets in the US. Four fifths are alpha, they get the average market return. One fifth are 'smart beta'. There are some arguments for them. One problem with passive index funding is that the biggest companies get the biggest weightings. They are bought more just because they are large, it is circular:

 

"What smart beta does best is sever the link between the price of a stock and its weight in an index, says Rob Arnott, chairman and co-founder of Research Affiliates in Newport Beach, California. Arnott has become a demigod in the movement since co-authoring the 2005 paper “Fundamental Indexation.’’ Research Affiliates indexes are used by fund companies to manage $180 billion of assets. “By linking the weight to price, the more expensive something is, the bigger your holding,’’ says Arnott, who received a bachelor’s degree in economics, applied mathematics, and computer science from the University of California at Santa Barbara. That means you’re buying some stocks because other people like them, he says, not because they’re better companies. “Why on earth would you want to do that?’’ he asks."

 

But just because there is a problem in one approach does not mean that, by avoiding the problem, you will get a better result. Smart beta funds have yet to prove that they work. And what especially matters is how much it costs to invest in them.

 

Here is a graph of the ETF growth:

 

 

 




Similar articles from Portfolio

Are investors their own worst enemy?

David James | 3/15/2015

Worst EnemyThe problem with human psychology is that it can get in the way of rational decision making. It is something to remember for those who have a DIY super fund.


SMSFs look abroad

 | 2/22/2015

Going global Analysis by the SMSFA suggests that as the global economy recovers, trustees are looking overseas.


The risks of 'cheap' shares

 | 12/4/2014

Danger"Buy on weakness" is a common stock broker recommendation. But are there dangers in purchasing shares when they have fallen? Some research suggests so.


Don't panic

 | 12/3/2014

PanicInvestors have a tendency to panic when markets become volatile. They can easily become become their own worst enemy.


The psychology of control

 | 10/28/2014

ControlSMSF super funds are usually set up so trustees can gain greater control over what happens to them. So when markets become volatile and it is apparent that nobody controls them, what are the psychological effects?


 

Subscribe

Subscribe to the Personal Super Investor weekly email to keep abreast of developments in SMSF law and investment markets. SMSF investors looking to improve investment returns from shares, property, cash or other specialised investments, will find the PSI weekly newsletter an invaluable resource.

Subscribe now »

Disclaimer

The contents of this website are of a general nature only and have not been prepared to take into account any particular investor's objectives, financial situation or particular needs. Our content is not intended to be advice and must not be relied upon as such. You should seek independent advice tailored to your specific circumstances prior to making any decisions. Personal Super Investor does not provide financial product advice or recommend any financial products: Where this website or it derived newsletter/electronic publication refers to a particular financial product, whether it be within our editorial or a 3rd party advertising, advertising promotion or advertorial, then you should obtain a Product Disclosure Statement (PDS) relating to that product and consider the PDS before making any decision about whether to acquire the product. We also recommend that you should seek professional advice from a financial adviser before making any decision to purchase any financial product referred to on this website. We do not make any representation or warranty that any material on the Personal Super Investor website will be reliable, accurate or complete, nor do we accept any responsibility arising in any way from errors or omissions of our content or any content provided by any advertiser appearing the Personal Super Investor website. We will not be liable for loss resulting from any action or decision by you in reliance on the Material (whether editorial or advertising) on the Personal Super Investor website, nor any interruption, delay in operation or transmission, virus, communications failure, Internet access difficulties, or malfunction in your equipment or software. By using the site you acknowledge that we are not responsible for, and accept no liability in relation to any content contained on the site that you may use, including any other users’ use of the Personal Super Investor website in any circumstance. You use the Personal Super Investor website at your sole risk.