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The Smart Beta Balancing Act

Maximizing factor-investing returns only over the long-term can put CIOs at risk of being fired over short-term performance, Research Affiliates argues.

The best performing smart beta allocations over the long term are also the most likely to get CIOs in hot water over short-term performance, according to a new Research Affiliates blog.

While the manager found that the value factor performed best over the last 50 years, allocating only to value strategies leads to high correlation and, therefore, short-term downside risk, wrote John West, Vitali Kalesnik, and Mark Clements.

Meanwhile, a 50-50 split between negatively correlated factors like value and growth has offered downside protection—and job security—by allowing an investor to “take both sides of the bet.” But playing it safe will "yield close to a zero expected return” over a full market cycle, the researchers said.

For the study, the managers examined the performance of eight long-only value strategies, four momentum strategies, four quality strategies, and eight growth strategies, plus four randomized portfolios with zero expected return, over a period between 1967 and 2016.

Value had the strongest performance of the factors, earning 2.25% in excess returns, while growth had the least value-add, underperforming the benchmark by 1.62%.

Using these funds, they built portfolios investing across a mix of eight strategies, ranging from an all value portfolio to a mix of three factors.

For a CIO to get fired, the trio said that more than 50% of the funds selected had to underperform the benchmark in a given period between 1 and 10 years, or the total portfolio had to underperform the benchmark by 1%.

Over all horizons and under both firing rules, investors who allocated only to value funds had "the highest chance of being fired because all the value strategies are highly positively correlated; thus, when one underperforms, they all tend to.”

Adding momentum decreased chances of being fired in all but one time horizon as “one style’s outperformance tends to offset the other style’s underperformance.” Further broadening the portfolio—by adding allocations to the random portfolios or to the quality factor—further minimized chances of being fired.

However, despite short-term losses, the value and value/momentum allocations had the best long-term performance on a total return and risk-adjusted basis, the researchers found.

“While both are sources of robust returns, the agent’s prospect of keeping her job is markedly improved by taking advantage of the diversification benefits of negatively correlated strategies, and allocating to value/momentum,” they wrote.

The researchers concluded that funds and boards should “better align incentives by adopting longer evaluation periods, combining multiple robust strategies, using non-robust strategies consciously, and practicing transparent management by individual style performance.”

Related:  Why Now is the Wrong Time to Buy Smart Beta

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