Robert Arnott of Research Affiliates, who created the strategy of fundamental indexing, has warned of a “smart beta crash” in the not-too-distant future, according to a Financial Post
“The argument for a crash goes something like this: With markets presumed efficient — at least over the long term — excessive fund flows into ETFs focusing on specific factors are bound to end in tears. Stocks fitting a given set of criteria risk will see indiscriminate inflows that stretch their valuations, skewing performance upward until the herds trample for the exits,” article author Yves Rebetez wrote.
While acknowledging the rationale for a crash, Rebetez was quick to explain that such narratives only identify ETFs as scapegoats. The reality is that unlike passive index investing, wherein the reaction to crash warnings is for investors to lower their exposure, smart beta ETFs can employ several different mechanisms to regain altitude before crashing.
Holdings of individual stocks in a smart beta ETF, for example, can be reset if there’s any suggestion that they become overpriced. The composition can essentially be reset with a new batch of better-suited securities.
The same can be done for momentum strategies: if a momentum stock held by the fund starts deteriorating, then other names with momentum will be incorporated.
Rebetez also pointed out that smart beta ETFs are not the only vehicles that rely on active strategies. “Others continue to pursue the same strategies outside of ETFs, which only serve to widen the access to such strategies,” he said.
“Investors who are looking to explore smart beta ETFs should understand that not all factors work at all times, and their relative performance versus the market or each other may provide opportunities to fine tune one’s exposure to the category at different points in the cycle,” he continued, explaining that the more likely scenario is for specific factors to underperform at different times.
“There is no doubt, for example, that the chase for yield has been fueled by ZIRP worldwide,” he said. “I wouldn’t expect a crash, but it would be wise in this case for investors to watch how the category fares if the Fed actually hikes rates in December.”
For investors who don’t want to be exposed to the possible underperformance of a single-factor strategy, Rebetez suggested that they opt for multi-factor strategies that balance portfolios according to different factors, and use different weightings to adjust exposure at different times.
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