Jason Williams, senior vice president at Lazard Asset Management, has written a white paper on the “six sins of smart beta.”

First: what is smart beta? Academic studies indicate anomalies in the markets that somehow don’t get arbitraged away.  These become identified as “factors” and indexes can be designed so as to weigh their components by that factor.  Then funds can follow those indexes, as automatically, and thus as passively, as a fund might follow an index where the components are weighted the old fashioned way, either equally or by size.

Smart-beta, then, may be defined as passive investing that aims to do better than passive investing. It works at that goal by looking to these anomalies (to some one of them for one index or fund typically) as the way forward, as the way to pluck the “low hanging fruit” consistent with the advantages of, well … passivity.  As Williams puts it in his paper, this has made smart beta “a new frontier in passive investing.”

Growth of a Strategy

Funds that employ this strategy “tend to employ a long-only, single-factor approach within a single asset class, typically equities, and are systematically implemented and rebalanced to maintain the factor exposure,” Williams writes.

The oldest “factors” to be employed in this smart-and-passive way are value and volatility. That’s been done for more than a decade. But other factors have been brought in to serve as the weighting device for an index, including momentum, quality, income yield, and size.

The expansion of types of smart beta has coincided (not coincidentally) with an expansion in the volume of assets devoted to such funds. Back in 2010, just a bit more than 2% of global assets under management were managed by this technique. The percentage involved crossed 3% in 2014 and 4% at the beginning of 2016.

The growth of the industry has created a concern over herding and negative feedback loops. Although Williams mentions those concerns, that is not a central focus of his paper. The focus, rather, is on the six sins.

The Six Sins

All six of the associated risks (“sins”) on which Williams founds his paper can threaten “sizeable drawdowns relative to the market” for an investor caught up in them.

  1. Entry point risk. This is the risk that an investor will get in at just the wrong time for a particular beta fund’s ‘smart’ feature, for example by entering a momentum-drive fund just before a ‘momentum crash.’
  2. Valuation risk. The risk (through a bias in favor of quality) of buying into a high priced portfolio, thus locking in low returns.
  3. Time horizon risk. Akin to entry point risk, but defined in terms of the expectation that an early drawdown will eventually be made good. Given that presumption, the time horizon of that “eventually” might just be too long, up to 12 years in one of the scenarios the paper considers. “It is easy to see why investors might choose to throw in the towel” before then.
  4. Risk model failure. “While the approach employed by risk models in calibrating and measuring stock risk is highly effective in most market environments, there are instances where these models fail. “
  5. Poor specification risk. This is the risk that “the investment metrics an investor uses to represent a factor exposure” will prove not to have been well chosen.
  6. Finally, there’s macro association risk, that is, the impact of a macro outcome on the performance of a factor or style.

Final Thoughts

Williams believes that the two most “notable of the smart-beta investing risks” he has highlighted are the fourth and fifth, that is, “an overreliance on any one measure of risk” on the one hands and “the choice of investment metric in expressing a factor” on the other.

The answer to sin is virtue: the answer to these risks is due diligence. Investors should get into the smart beta field with their eyes open, without the naïve belief that adding the “smart” features is just “a small step in the evolution of passive investing.”