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How Long Will You Wait For Smart Beta To Work?

In my last post I shared some insights from Ben Carlson’s A Wealth of Common Sense , which argues that investors are generally better off keeping their portfolios simple and straightforward. This idea has little appeal for index investors who hope to improve on plain-vanilla funds by using so-called smart beta strategies. “Smart beta” refers to any rules-based strategy that attempts to outperform traditional cap-weighted index funds. Now more than a decade old, fundamental indexing is the granddaddy of smart beta, while factor-based strategies are the newer kids on the block. In each case, the goal is to build a diversified fund that gives more weight to stocks with certain characteristics (value, small-cap, momentum, and so on) that have delivered higher returns than the broad market over the long term. Many proponents of passive investing see huge potential in factor-based strategies because they combine the best features of indexing-low-cost, broad diversification, and a rules-based process-with the potential to overcome the shortcomings of traditional cap-weighting. Indeed, many of our clients at PWL Capital use a combination of traditional ETFs and equity funds from Dimensional Fund Advisors (DFA) , which have greater exposure to the small-cap, value and profitability factors . The academic research on factor-based investing is robust and convincing, and building your portfolio using these principles may be rewarding over the long term. Ben Carlson thinks so, too, despite the emphasis he puts on simplicity. But he has some cautionary words for those who are ready to jump on the smart beta bandwagon. “I think these strategies can make sense as part of a broadly diversified portfolio if you know what you’re getting yourself into,” he writes. A costlier, bumpier ride Let’s start with the most obvious caveat: smart beta is cheap compared with active strategies, but it’s significantly more costly then traditional ETFs. Cap-weighted ETFs carry almost negligible costs these days, with fees as low as 0.05%, while factor-based funds tend to have MERs in the range of 0.40% to 0.80%. That means they need to deliver significant outperformance before fees to simply break even on an after-cost basis. Second, any outperformance is probably going to involve a rockier ride. While it’s not true over every period, small-cap and value stocks are typically more volatile than the broad market, so their excess returns may require you to endure more swings in your portfolio. Over the last five years, for example, that standard deviation (a measure of volatility) for both value and small cap stocks was higher than that of the broad market in Canada, the U.S. and international markets. And as Carlson notes: “One of my common sense rules of thumb states that as the expected returns and volatility of an investment increase, so too does poor behavior.” Which brings us to the biggest challenge for investors who use smart beta strategies. The waiting is the hardest part Investors who embrace smart strategies are usually familiar with the research showing that small-cap and value stocks have outperformed over the very long term in almost every region. But few appreciate that to those premiums can take a long time to show up-and were not talking about a mere five or 10 years. In his book, Carlson explains that from 1930 to 2013, small-cap value stocks in the US delivered an annualized return of 14.4%, compared with 9.7% for large caps. However, small-cap value lagged the S&P 500 for a 15-year stretch in the 1950s and 1960s, then for seven more years from 1969 to 1976, and finally for a gruelling string of 18 years in the 1980s and 1990s. “Eventually they paid off, but that’s a long time for investors to wait. Patience is a prerequisite for these strategies.” That’s an understatement. It’s not uncommon for investors to lose faith in a strategy after a year or two. It’s hard to imagine many will hang on to an underperforming smart beta fund as it lags the market for even five years-let alone 18-because they’re confident it will outperform over a lifetime. Almost no one has that kind of patience-with the possible exception of Leafs fans . “You have to commit to these types of strategies, not use them when they feel comfortable,” Carlson says. “The reason certain strategies work over the long term is because sometimes they don’t work over the short to intermediate term.” Tracking error regret Just this week, Larry Swedroe expanded on this idea by looking at the probability that the small and value premiums will be negative over various periods. He demonstrates that there’s a significant chance of underperformance over even a decade or two. “My almost 20 years of experience as a financial advisor has taught me that even the most disciplined investors can have their patience sorely tested by as little as even a few years of underperformance,” he confirms, “let alone a 10-year period without higher returns for value (or small, or international, or emerging market) stocks.” Swedroe goes on to coin a brilliant term for the anxiety indexers feel when their smart beta strategies go awry: tracking error regret . “These are investors who regret their decision to maintain a portfolio that performs differently than the market. Tracking error regret causes many investors to abandon their well-thought-out, long-term plans.” The point here is not that you should ignore alternatives to portfolios built from traditional index funds. Smart beta strategies may indeed reward the patient, disciplined investor over the very long term. But no investors should ever feel they’re settling for second-best with a simple solution. In the end, these traditionalists will likely find it easier to stay on course, and may just end up looking like the smart ones.

To Be (The Market) Or Not To Be?

Key highlights After significant losses by large-capitalization and growth stocks during the 2000-2002 bear market, investors have become increasingly interested in non-market-cap index-weighting strategies that intentionally divorce a security’s index weighting from its price. Such rules-based alternatives to market-cap-weighted indexes include strategies labeled alternative indexing, fundamental indexing or, more commonly used, smart beta. Vanguard believes strongly that, by definition, smart beta indexes should be considered rules-based active strategies because their methodologies tend to generate meaningful security-level deviations, or tracking error, compared with a broad market-cap index. Our research shows that such strategies’ “excess return” can be partly (and in some cases largely) explained by time-varying exposures to various risk factors, such as size and style. Place “the market” in front of a mirror and what would you see? A perfect reflection of that market-same size and shape, nothing added, nothing taken away. If you wanted the reflection to show something different from the market-something better?-you’d need to place something different in front of the mirror. That’s the puzzle of smart beta, whose providers often suggest that they’re “like the market,” only better. If you’re looking to get different returns from, for example, the U.K. stock market, “you have to look different in some way, shape, or form,” said Don Bennyhoff, senior investment analyst in Vanguard Investment Strategy Group. “The first thing smart beta providers do is modify what the market looks like, based on their own active choices and biases.” Recent research by Bennyhoff and his colleagues Christopher Philips, Fran Kinniry, Todd Schlanger, and Paul Chin found that the rules-based methodologies employed by alternatives to market-cap-weighted indexes tend to generate meaningful tracking error compared with broad market-cap indexes. The methodologies may weight securities differently from their market-cap weighting. Or they may exclude securities that feature in a benchmark and include securities that aren’t part of the benchmark. “In our opinion,” Bennyhoff said, “these rules-based strategies are active, which means they’re not asset-class beta or ‘the market’ in the traditional sense.” The sources of outperformance “These strategies tend to result in portfolios that emphasize smaller-cap or value stocks, which have performed very well since the early 2000s,” Bennyhoff said. “So the question is, ‘Are these higher returns the result of higher risks?’ There is rigorous debate about that topic. But when we look at risk-adjusted returns, the excess return tends to go away, and maybe that’s a meaningful finding.” Moreover, as the figure below shows, smart beta strategies’ exposures to risk factors change over time. Non-market-cap-weighted strategies’ exposures to risk factors are time-varying 60-month rolling style and size exposure of alternative index versus broad developed-equity market, 1999-2014 Source: Illustration by Vanguard, based on data from MSCI, FTSE, S&P Dow Jones Indices, and Thomson Reuters Datastream. Figure displays 60-month rolling inferred benchmark weights resulting from tracking error minimization for each index across size and style indexes. Factors are represented by the following benchmarks: fundamental-weighted-FTSE RAFI Developed 1000 Index; equal-weighted-MSCI World Equal Weighted Index; GDP-weighted-MSCI World GDP Weighted Index; minimum volatility-MSCI World Minimum Volatility Index; risk-weighted-MSCI World Risk Weighted Index; dividend-weighted-STOXX Global Select Dividend 100 Index. “We’re not saying that paying attention to factors or tilting on value or small-cap is necessarily a bad thing,” Bennyhoff said. “Whether they pay off in the future as they’ve paid off in the past remains to be seen. But instead of putting together a strategy where the factor exposure is a by-product of the weighting scheme or the security-selection scheme, maybe it should be the primary focus .” And if you’re looking to capture the risk and reward of an asset class, Bennyhoff says, “the only way you can reflect that aggregate capital invested in the asset class is through market-cap weighting.” Interested in an overview of smart beta and other rules-based active strategies? Read our research brief . Notes: All investing is subject to risk, including possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Morningstar Ratings Of Target Date Funds Are Obsolete

Asset allocation is the primary determinant of investment performance and risk. Many say asset allocation explains more than 90% of investment results, but the fact is that it explains more than 100% . Because of this importance, we provide a detailed examination of target date fund glide paths in order to differentiate the good from the bad. Our focus is on fiduciary responsibility and the characteristics of a glide path that make it Prudent. Prudent glide paths are good. Imprudent glide paths are not good for both beneficiaries and fiduciaries. Fiduciaries face possible legal action for imprudent TDF selections. A glide path does not have to produce high returns to be Prudent. In fact, high returns can be an indication of imprudent risk taking. We use the PIMCO Glide Path Analyzer in the following to examine TDF Prudence and to develop Prudence Ratings that differ from Morningstar Ratings. Morningstar Ratings tend to penalize Prudence. Click to enlarge Defining Prudence The three great benefits of target date funds are diversification and risk control provided at a reasonable cost. All three of these benefits vary widely across target date fund providers, as shown on the right of the above graph. Looking to the left of the graph at long terms to target date, we see consensus in high equity allocation – the lines cluster. The differentiator at long dates is diversification. Theory states, and evidence confirms, that diversification improves the risk-reward profile of a portfolio. Greater diversification leads to higher returns per unit of risk, and is a benefit of TDFs. Looking to the right of the graph, near the target date, we see wide disagreement, with equity allocations at target date ranging from a high of 70% to a low of 20%. The prudent choice is safety at the target date, the other benefit of TDFs. These two key benefits, plus fees, are discussed in the following in the order of their importance. The most important benefit is safety at the target date Safety at the target date is the most important benefit for the following reasons: There is no fiduciary upside to taking risk at the target date. Only downside. The next 2008 will bring class action lawsuits. There is a “risk zone” spanning the 5 years preceding and following retirement during which lifestyles are at stake. Account balances are at their highest and a participant’s ability to work longer and/or save more is limited. You only get to do this once; no do-overs. Most participants withdraw their accounts at the target date, so “target death” (i.e., “Through”) funds are absurd, and built for profit. All TDFs are de facto “To” funds. Save and protect. The best individual course of action is to save enough and avoid capital losses. Employers should educate employees about the importance of saving, and report on saving adequacy. Prior to the Pension Protection Act of 2006, default investments were cash. Has the Act changed the risk appetite of those nearing retirement? Surveys say no. Click to enlarge As you can see in the following graph from PIMCO’s Glide Path Analyzer, only a handful of TDFs provide true safety at the target date. The second most important benefit is reasonable cost Fees undermine investment performance and are the basis for several successful lawsuits. You can be the judge of what is reasonable, keeping in mind that you want to get what you pay for. The challenge for plan providers is achieving good diversification for a reasonable cost. Assets that diversify, like commodities and real estate, are expensive. As shown in the following graph, only a handful of TDFs are low cost, similar to the scarcity of TDFs that provide safety at the target date. You need to ask yourself what you get for a high fee that you can’t get for a much lower fee. Fees Click to enlarge Diversification is the third most important benefit ” A picture is worth a thousand words.” Diversification is readily visualized as the number of distinct asset classes in the glide path, especially at long dates. The following are examples of well diversified TDFs, as seen through the lens of PIMCO’s Glide Path Analyzer. Keep these images in mind when you view the other glide paths shown in the next section. Think “A rainbow of colors is diversified.” Click to enlarge Common Practices Most assets in target date funds are invested with the Big 3 bundled service providers and with funds that have high Morningstar ratings. Here are the glide paths for these common practices. Click to enlarge Fidelity is the most diversified of this group, as indicated by the color spectrum at long dates (40 years). All three end at the target date with more than 50% in risky assets, which is not safe. As shown in the risk graph above, the Big 3 are low on the list of safety at the target date. Click to enlarge High Morningstar ratings go to funds with a high concentration in US stocks because US stocks have performed very well in the past 5 years. High Performance is not the same as Prudence. In fact, it’s currently an indication of imprudent risk concentrated in US stocks. Putting it all together: Prudence scores To summarize, some TDFs provide good safety, while others provide broad diversification, and still others provide low fees. To integrate these three benefits we’ve created a composite Prudence Score, detailed in the Appendix. The graph on the right shows the Top 20 Prudence Scores and compares them to Morningstar Ratings. The tendency is for the 8 highest prudence scores to get low Morningstar ratings. Four of the Top 8 have Morningstar ratings below 3. Prudence scores below the top 8 tend to get Morningstar ratings above 3.5 stars. The difference of course is performance, especially recent performance that has benefited from high US equity exposures. This “Group of 8” deserves your attention. Conclusion Fiduciaries now have a choice between TDF rating systems that are quite different. You can choose between Prudence and Performance. The cost of Prudence in rising markets is sacrificed Performance, but this sacrifice pays off in declining markets and can easily compensate for sacrifices. We hope you find this glide path report and Prudence Score helpful. We also hope that plan fiduciaries will vet their TDF selection. The fact that more than 60% of TDF assets are with the Big 3 bundled service providers suggests that fiduciaries are not considering alternative TDFs, so participants might not be getting the best; they’re simply getting the biggest. See our Infographic for more detail. Endnote Many thanks to PIMCO for letting me use their Glide Path Analyzer. It’s great. That said, the views expressed in this report are strictly my own. Disclosure : I sub-advise the SMART Target Date Fund Index that is included in this report. It’s treated exactly the same as all the other funds. Appendix: Constructing Prudence Scores The Prudence Score is not very quantitative, & much simpler than Morningstar ratings. It uses only 3 pieces of information: Fees: obtained from Morningstar # of diversifying risky assets at long dates: I counted these, & excluded allocations that are less than 1%. Some funds have meaningless allocations to commodities for example. Safety at target date: % allocation to cash & other safe assets, like short term bonds & TIPS. Here’s the table I filled out by hand: Company Fee (bps) # Risky % Safe SMART Index – Hand B&T 34 6 90 PIMCO RealPath Blend 28 6 30 Allianz 90 6 40 John Hancock Ret Choice 69 5 40 PIMCO RealPath 65 6 30 JP Morgan 82 6 30 Harbor 71 4 35 Blackrock Living Thru 98 5 35 Wells Fargo 53 5 25 Invesco 111 4 40 Putnam 105 3 40 MFS 102 6 25 Schwab 73 3 30 Guidestone 121 5 30 DWS 100 5 25 USAA 80 4 25 BMO 68 3 25 Franklin LifeSmart 110 5 25 TIAA-CREF 21 3 15 Vanguard 17 4 10 Hartford 117 5 25 Voya 113 6 20 Nationwide 89 6 15 American Century 96 4 20 Principal 86 6 10 Russell 92 5 15 Alliance Bernstein 101 4 20 Mass Mutual 97 5 15 T Rowe Price 79 4 15 Fidelity Index 16 3 5 Great West L1 99 4 15 Blackrock 98 5 10 John Hancock Ret Living 91 5 5 Great West L2 102 4 10 Manning & Napier 105 4 10 Fidelity 63 3 5 Mainstay 92 3 10 American Funds 93 3 10 Legg Mason 139 5 10 Franklin Templeton 110 4 8 Great West L3 95 4 5 State Farm 119 4 5 The next step is a little quantitative. I made up some rules for the importance of each factor: Safety got the highest importance. I adjusted the “% safe” allocations so the safest got a score of 25 Fees are 2nd in importance. I weighted them at 15. Diversification gets a max score of 10 Then I add the 3 scores for each & divide this sum by 10, so the highest composite score is 5: (25 + 15 +10)/10 The 1st table is totally verifiable. We can discuss the weighting scheme in the following 2nd table: Prudence Scores Company Fee (15) Divers(10) Protect(25) Prudence Mstar SMART Index – Hand B&T 12.8 10 25.0 4.8 1.5 PIMCO RealPath Blend 13.5 10 25.0 4.2 4 Allianz 6.0 10 25.0 4.1 1 John Hancock Ret Choice 8.5 7.5 25.0 4.1 2.9 PIMCO RealPath 9.0 10 18.8 3.8 4 JP Morgan 7.0 10 18.8 3.6 4 Harbor 8.3 5 21.9 3.5 3.4 Blackrock Living Thru 5.0 7.5 21.9 3.4 3.2 Wells Fargo 10.5 7.5 15.6 3.4 1 Invesco 3.4 5 25.0 3.3 4 Putnam 4.1 2.5 25.0 3.2 3.1 MFS 4.5 10 15.6 3.0 3.6 Schwab 8.1 2.5 18.8 2.9 3.6 Guidestone 2.2 7.5 18.8 2.8 3.3 DWS 4.8 7.5 15.6 2.8 3.3 USAA 7.2 5 15.6 2.8 3.5 BMO 8.7 2.5 15.6 2.7 4 Franklin LifeSmart 3.5 7.5 15.6 2.7 4 TIAA-CREF 14.4 2.5 9.4 2.6 3.5 Vanguard 14.9 5 6.3 2.6 3.5 Hartford 2.7 7.5 15.6 2.6 3.8 Voya 3.2 10 12.5 2.6 2.8 Nationwide 6.1 10 9.4 2.5 3.5 American Century 5.2 5 12.5 2.3 2.8 Principal 6.5 10 6.3 2.3 3.3 Russell 5.7 7.5 9.4 2.3 3.3 Alliance Bernstein 4.6 5 12.5 2.2 3.6 Mass Mutual 5.1 7.5 9.4 2.2 3.7 T Rowe Price 7.3 5 9.4 2.2 3.7 Fidelity Index 15.0 2.5 3.1 2.1 3.1 Great West L1 4.9 5 9.4 1.9 3.3 Blackrock 5.0 7.5 6.3 1.9 3.3 John Hancock Ret Living 5.9 7.5 3.1 1.6 3.2 Great West L2 4.5 5 6.3 1.6 3.4 Manning & Napier 4.1 5 6.25 1.5 4.2 Fidelity 9.3 2.5 3.1 1.5 3.3 Mainstay 5.7 2.5 6.3 1.4 3.6 American Funds 5.6 2.5 6.3 1.4 4.1 Legg Mason 0.0 7.5 6.3 1.4 3.3 Franklin Templeton 3.5 5 5.0 1.4 4 Great West L3 5.4 5 3.1 1.3 3.5 State Farm 2.4 5 3.1 1.1 3.2 PAGE * MERGEFORMAT 10 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.