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Everybody wants to beat the market.  That aspiration is in the make up of market participants.  It has been and will be. Stating the obvious, to beat the market you have to be different.  That’s a truth that active management has overcome with national distribution channels for a long time, but things are changing.  As more and more advisers and investors gain access to common sense information, the demand for “active” managers that do nothing more then track a broad market index is going to zero.  The demand is shifting towards managers that are active in their methodology (different from the benchmark) but transparent in the potential value that difference brings.  Enter smart beta…

Smart beta strategies, for the most part, attempt to skew market exposure towards certain factors that have shown historical returns that seem to contradict the notion of efficient market hypothesis: meaning, this exposure has generated superior returns vs the market.   Some of these factors would include Momentum, Value, Quality, Low Volatility, etc.

We came across the Factor-Quilt pictured below through an ETF Trends article by John Lunt.  Typically, this quilt illustrates the annual returns at the asset class (US Stocks, Commodities, Bonds, etc)  level and is accompanied by commentary discussing the importance of diversification.  This quilt, on the other hand, illustrates the annual returns of each factor within the Large Cap US Stock market.  It’s a visual tool that has aided our discussions within the advisory community, not so much on diversification, but on the behavioral side of finance.

Smart beta products will surely provide compelling evidence.  If the ultimate goal is to bring value to the end user, evidence is not the issue. It’s the positioning of the evidence that matters. A strategy’s return is meaningless.  It’s the investor’s return while exposed to the strategy that counts.

If investors are not properly equipped, the evidence has ZERO chance of playing out in their real world portfolios.  Don’t sell the upside and position products or strategies as market beaters…that’s a loser’s game for all involved.  Just look at arguably the hottest factor, Low Volatility, and how volatile the good and the bad can be via John Lunt’s Article:

“The period of 2014 through the end of Q2 2016 was a season of outperformance for low volatility. This helped investors forget the low volatility factor underperformed the S&P 500 in 2009, 2010, 2012, and 2013. In fact, it was the poorest performing factor during three of those years.  During the first half of 2016, the low volatility factor was the star, up 12.32% while the S&P 500 was up 3.84%.  From July 1 to November 30, the low volatility factor was a villain, down 4.19% while the S&P 500 was up 5.73%.”

Only those that stuck with Low Vol strategies during 2009, 2010, 2012, and 2013 benefited from it’s outperformance during 2014 and 2015.  My guess, those investors were a dime a dozen.  My other guess would be that money chased Low Vol at the start of 16….I’d love to see those numbers if anybody has them.

Evidence should be there, it’s the ability to stick to the strategy during bad times to see it through to the good times that matters.  Both advisers and investors should engage in the needed activity to increase sticking power.  Understand when it will look good and when it will look bad.  Don’t fool yourself into thinking you stumbled upon the factor that always looks good….that doesn’t exist.

Take a look at the quilt below to identify the volatility in factor leadership.  This volatility is typical of markets and only creates further potential for a persistent behavior gap as we humans are so quick to fix things when they appear to be broken.  Equip yourself with knowledge and understanding so you can suppress the urge to fix things and increase your sticking power.  When reviewing the gamut of smart beta strategies please remember, simple beats complex.