Brent Leadbetter is a product specialist for RAFI Fundamental Index strategies. In this role, he helps investors understand the RAFI methodology and the potential roles of smart beta strategies. We recently caught up with Leadbetter, who will be speaking at our 2nd Annual Smart Beta Strategies Summit (Oct. 26 – Boston) to hear his views on portfolio construction and performance chasing.
Financial Advisor magazine: Where does smart beta belong in a portfolio?
Brent Leadbetter: We believe it is important to demystify the term “smart beta”. In “What ‘Smart Beta’ Means to Us,” we specify that in order for a strategy to qualify as smart beta it should retain the benefits of traditional passive investing while breaking the link between the price of an asset and its portfolio weight. Strategies that adhere to this definition are appropriate for a number of uses. Non-cap weighted indices serve as excellent diversifiers to traditional passive indices and introduce the potential for excess returns. These strategies may also serve as an effective replacement for disappointing active managers.
Some advisors have chosen to set aside a dedicated allocation for smart beta strategies. While this segregation is a reasonable approach we do not believe it is required in order to use smart beta portfolios. These strategies can often fit nicely within an existing allocation.
For example, advisors that are concerned due to a change at the helm of an actively managed value strategy may find a value-biased smart beta strategy serves as an excellent replacement. A rules-based strategy that weights companies by non-price measures of size will generally incorporate many of the tenets of traditional Graham and Dodd value investing via a completely emotion-free, predictable and disciplined portfolio construction process. Simultaneously, advisors that are looking to generate excess returns from their passive allocations given today’s low return environment often find smart beta strategies’ combination of low monitoring costs and potential for excess returns appealing.
Product proliferation in the smart beta space has created confusion. Our intention when we launched the RAFI Fundamental Index strategies in 2005 was to introduce an intuitive suite of strategies that retained the benefits of passive investing—low trading costs, transparency, diversification and broad economic representation—while incorporating the potential for excess returns by weighting according to metrics other than the price of the constituent firms.
FA: There are still some who are attracted to the idea of using factors tactically—is this appropriate?
Leadbetter: Yes! We have argued for years that performance chasing is one of the primary contributors to wealth destruction, most recently in “The Folly of Hiring Winners and Firing Losers.” Buying that which has performed well, and is now newly expensive, is a sure way to generate poor returns.
Most advisors are well aware that performance chasing is dangerous when applied to asset classes. This is why advisors devote a great deal of time to ensuring their clients stay invested during challenging periods.
At a basic level, equity factors are no different from asset classes. Their performance and valuation vary over time. Factors that have recently performed well become expensive. Factors that have recently performed poorly become cheap. Instead of chasing this performance, we do the exact opposite.
Our RAFI Dynamic Multi-Factor Index strategies increase the allocation of cheap factors at the expense of expensive ones. Because most clients choose multi-factor strategies at least in part due to their inherent diversification across multiple factors we place limits on our rebalancing. We always maintain a minimum of a 5 percent allocation to each of the five factors we employ—value, size, low vol, quality and momentum—and we cap each at a maximum of 35 percent. We have found that our intuitive weighting approach accomplishes a goal that is appealing to many investors in theory but difficult to achieve in practice. We buy the unpopular, attractively priced factors while selling the popular, expensive factors in order to position our portfolios to benefit from mean reversion.
FA: Thanks, Brent. We look forward to hearing more of your thoughts at the 2nd Annual Smart Beta Strategies Summit October 26th in Boston.