If Smart Beta could think would it anticipate
macro/sector/industry drivers, corporate actions, Fed Policy or
externalities? Would Smart Beta apply
the Free Cash Flow theory to evaluate dividend policy, the absence thereof or
share repurchase programs and amend its ethos?
The long-term benefit of actively defined
parameters in passive capital market Smart Beta constructed products is
supported by over 40 years of data, illustrated in the 5-year period chart
below. Displayed are Smart Beta
standard-bearers PowerShares FTSE RAFI US 1500 Small-Mid Portfolio (PRFZ) and
PowerShares FTSE RAFI US 1000 Portfolio (PRF) against the performance of market
weighted peer benchmarks iShares Russell 1000 Value ETF (IWD), iShares Russell
2000 Growth ETF (IWO) and iShares Russell 1000 ETF (IWB). Empirically the Fundamental indexes provide
superior returns relative to market capitalization weighted composite benchmark
portfolios and on a standalone basis.
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In shorter periods of performance measurement,
divergence among benchmarks is evident as embedded Alpha across portfolios
accounts for the variability relative to the benchmarks PRFZ and PRF.
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Within the Fundamental indexes matrix,
variability in near- and intermediate-term performance suggests Smart Beta’s
equally weighted parameters—book value, cash flow, sales, dividends—mask Alpha
drivers when aggregated, unable to detect relevant points of inflection beyond
contrasting the price change of respective Smart Beta indexes and their
corresponding mean-variances. In this
context Smart Beta may offer excess market or asset class returns though does
not offer Alpha generation, per se, but rather enhanced Beta long-term
outperformance representing more of a paradigm shift in theoretical Beta—CAPM
2.0.
The comparative 6-month chart below displays
both Alpha and negative Alpha. Demonstrated by the inclusion of PowerShares
WilderHill Clean Energy Portfolio (PBW), relative out(under)performance of
Smart Beta is exaggerated by further skewing capitalization bias and
combining the additional risks of thematic investing.
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Contrasting performance differentials is a
productive exercise as thematic investing is excluded from Smart Beta due to
the inconsistency of data relative to its thesis. Expectedly, causality ranges among many
factors; more importantly, one can anticipate the persistent lead and lag
effects characteristic among asset classes across capitalizations and within
verticals in diverse economic sectors.
In this context, corporate performance (Alpha)
is best analyzed during a one- to three-year operating environment and three-
to five-year business cycle (cyclical and secular). The sensitivity of these companies to
microeconomic and product sub-cycles within greater cyclicalities often provide
the quantifiable points of inflection the value bias in Smart Beta
ignores. Due to the finite nature of
Fundamental Indexation, Smart Beta asset class benchmarks exclude complete
measurement of growth companies engaged in emerging technologies based on its
own metrics.
For example, the simple presence of a dividend
policy infers the inability of a company to develop new projects or products
with an internal rate of return greater than its hurdle rate thereby
necessitating the return of excess cash to shareholders (as does a share
repurchase program). Growing companies
may in fact have negative retained earnings and deteriorating book value with
negative cash flow all the while realizing accelerating sales, an increasing
market capitalization and lofty valuation multiples (albeit with negative P/E
ratios).
Intuitively, the general composition profile and
even the broad 10 sectors detailed in the Smart Beta construct are
comparatively inadequate. The added
capability to assess economic behavior and market risk by aligning the business
segment operations of companies separate from the permutations of
sector/industry/subindustry classifications and array of proprietary indexes,
asset classes and geography produces Alpha.
Standardization of assigned nomenclature is complementary to the proven
financial metrics provided by Smart Beta strategies.
This reconciliation readily identifies the
common tangential profiles of multinational corporations, regional players and
new entrants plus captures determinants of valuation. For with all the Smart Beta packaging derived
from Town Hall convention against the purposefully obfuscated complexity of
Wall Street (together with its new arbiters), Main Street is not likely to
think much of regression analysis or a state of contango but if someone called
a cat a truck and said all dogs were the same they would surely take issue.
The fundamental parameters defined in Smart Beta
may indeed refine Modern Portfolio Theory (Markowitz 1952, 2009) and arguably
establish a more efficient frontier.
However, the qualitative assessments associated with quantitative analysis
dictate that optimal excess return relative to a benchmark requires both
performance attribution and an extrapolation of Alpha to include corporate
business planning and strategy independent of the characteristics of the
portfolio as a whole. In its current
state, Smart Beta appears to be more of a Beta booster than an Alpha driver
though does advance the continued evolution from Fundamental indexes to Applied
Indexation.
Published research serves as both a quantitative reference and instructional resource in addition to a template for client services. Metrics may be modified to accommodate the universe of sector, industry and subindustry research. For assistance implementing the aforementioned concepts within your financial/economic models or investment research process, please note three levels of consultation: Qualitative – Support, Quantitative – Directed and Quantitative – Fundamental.
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