This story appears in the June 14, 2015 issue of Forbes. Subscribe
Low-vol stocks like Kroger and Visa did surprisingly well. That doesn't make them a buy now.
In 1999 it was dot-com new issues. In 1957 uranium mining stocks were hot. In 1637 investors were overweight tulip bulbs.
An ever present hazard on Wall Street is the risk of falling prey to an investing fad. I see one building right now. I can see it by looking at the press releases that float in over the transom. The frenzy of the moment is "smart beta."
A beta coefficient, by itself, is a legitimate measure of the risk in a portfolio. If it's 1.5, then the portfolio is expected to lurch up 15% when the market goes up 10%, or down 15% if the market goes down 10%. A fundamental law of investing says that risk cuts both ways.
Smart beta is a little less fundamental. It's the notion that you can beat the market by fiddling with the buttons on your stock screen. You could, for example, change the way you weight the positions in a portfolio. Instead of holding stakes proportional to each company's market capitalization, as stock indexes traditionally do, you could weight them equally or weight them according to book value, dividends or earnings.
Like all fads, this one worked at the beginning. Robert Arnott, an innovator in alternative portfolio weights, has done very well with a business built on Rafi (Research Affiliates Fundamental Index) stock-weighting formulas. You can get Rafi-flavored mutual funds and exchange-traded funds.
And as with all fads, the innovators were followed by imitators and the imitators are now being followed by idiots. Scores of smart-beta funds are drawing in late-coming customers. They have hoovered up $400 billion or so of investor money.
A variation on the theme, reaching fever pitch in product announcements, is "low-volatility" investing. (Low-volatility stocks are not synonymous with low-beta stocks, but there is a lot of overlap.) Here in my in-box is a press release trumpeting a whole suite of low-vol funds. The declared aim is "taking advantage of the equity market's potential upside while providing protection from potential downturns."
Wouldn't it be great to outsmart beta? To have some system for getting 100% of the gain but suffering only 80% of the loss?
The grand idea started when academics discovered an "anomaly" in stock prices: Low-beta stocks like Kroger and Visa have done better than you would have expected, given their lower risk. In theory you could have mechanically harvested a pile of low-beta stocks, leveraged up the portfolio to where it was just as risky as the overall market and then beaten the market by a mile.
Alas, moneymaking anomalies don't persist. Once they are discovered, they are priced away. Given the popularity of ETFs chasing after low volatility, it's a good bet that low-beta stocks are collectively overpriced now.
In 2011 this column gave a favorable mention to Arnott's weighting scheme, suggesting that it was a way to bet against market fads and lighten up on overbought sectors. It might be able to deliver an extra half a point a year of performance, I guessed. Nowadays, with all the copycats on Arnott's tail, I'd temper that prediction. Maybe you'll land an extra quarter of a point. Consider Powershares FTSE Rafi U.S. 1000 ETF (PRF, 94), but don't expect wondrous performance.
As for the many imitators who are turning Arnott's idea into a hype factory, be wary. I went looking for a poster child of the smart-beta phenom and found something called First Trust Multi Cap Growth Alphadex ETF. It's an equally weighted collection of 495 stocks scientifically selected to generate "alpha," which is a fancy way of saying that you beat the market.
Do you? Over the past five years the Alphadex product, which costs 0.7% a year, has earned a compound annual 15.6%. You could have done 16.2% with a plain old S&P 500 index fund costing a tenth as much.
Best of all is the ticker for the Alphadex fund. It's FAD.
