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When Will Smart Beta Be Smart?

Allan Roth

How long will it take for smart beta ETFs to actually be smart?

Five years ago, warning signs were sounding an alarm. I couldn’t go 60 seconds at any financial conference without hearing the terms “smart beta” or “fundamental indexing.”

Many investors saw smart beta ETFs as a free lunch, and poured money into these strategies. Who would buy those overvalued large cap growth stocks when smart beta was smoking hot?

Herd Steered Wrong

It turns out the herd was wrong yet again. I started writing about why I was embracing dumb beta. The original two factors beyond beta—size and value—had horrific returns over the past five years. The so-called overvalued large cap growth stocks ended up being undervalued.

According to Morningstar, over the past five years ending June 30, 2019, small cap value gained a measly 4.07% annually compared with large cap growth’s whopping 13.20% annualized return. U.S. stocks as a whole gained 10.34% annually.

In other words, those “overvalued stocks” racked up more than four times the return of so-called undervalued small cap value stocks.

 

 

Excuses, Excuses, Excuses

I point out these dismal returns to smart beta proponents, and get responses similar to this one showing how small cap value has outperformed since 1926.

How different is this looking at something like Fidelity Magellan (FMAGX) having outperformed since inception? Of course, Magellan started out with market-trouncing returns and then, after money poured in, underperformed badly.

How Long To Recover?

Unlike Fidelity Magellan, there is some academic support for the small cap value premium. However, Eugene Fama and Ken French never said it was a free lunch that invalidated the efficient markets. Rather, it was compensation for taking on more risk, and that risk has played out since money poured in.

Now, no one knows future returns, but assuming the small cap value premium still exists, I thought I’d look at how long one would have to stay invested to recover from the shortfall over the past five years.

I made the following assumptions for annualized geometric returns:

U.S. Stock

7.0%

Large Growth

6.5%

Small Value

9.0%

 

Granted, my assumption of a 2% premium over the market is less than what we’ve seen since 1926, but so are my total annualized returns. I’m not convinced I’m being too conservative on any of these assumptions.

With these assumptions, it will take 16 years for small value to catch up to U.S. stocks overall, and 20 years to catch up to those so-called overvalued large cap growth stocks. This would make up for the five-year shortfall.

 

 

Lessons Learned

Whenever money pours in to part of the market, it is a warning sign that it is overvalued, and future returns will be lower. It doesn’t matter how much academic research supports it. Hot investments tend to cool off quickly.

Low-cost funds such as the iShares S&P Small-Cap 600 Value ETF (IJS) are viable low-cost strategies, but aren’t free lunches. Any claims that a certain stock is overvalued are suspect.

While I’m intrigued enough to now want to tilt my portfolio toward small cap value because of such underperformance, I’m sticking with dumb-beta, cap-weighted ETFs like the Vanguard Total Stock Market ETF (VTI), or the iShares Core S&P Total U.S. Stock Market ETF (ITOT). William Sharpe’s simple paper, The Arithmetic of Active Management, proves I’m going to best the average investor.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He has been a nonpaid panelist at one of NGPF's conferences for high-school teachers, but is not part of its organization. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at ar@DareToBeDull.com, or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

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