From an aggregate perspective, there’s no question that the ETF space is on a tear. Globally, ETF assets reached US$4.7 trillion in AUM last year, and BMO analysts expect that figure to exceed US$10 trillion in five years. Canada is expected to surge even more, with anticipated ETF asset growth from $156 billion to $400 billion.
A major tailwind behind that boom, noted BMO, has been the rise of passive ETFs. While they’re not expected to go out of fashion anytime soon, there’s a growing movement for them to be used with active strategies, which will act as satellite holdings. And for those who want to go beyond cap-weighted exposure, there’s a growing diversity of factor and smart-beta funds to choose from.
But according to new research from Scientific Beta, a smart-beta index provider funded by US think tank EDHEC Risk Institute, those seeking to invest in smart-beta strategies may want to beware. The problem, as reported by Institutional Investor, is that asset managers and index providers are drifting away from the factors that have been tried and tested by decades of academic research.
Students of Eugene Fama and Kenneth French should know about value, growth, and size. Ever since they published their ground-breaking research, others have explored the potential of other factors such as volatility and momentum to deliver investment outperformance in different market conditions and stages of the business cycle. That has led to numerous time-tested factors that underlie many strategies today.
But the Scientific Beta paper, titled The Risks of Deviating from Academically-Validated Factors, raises the question of reliability. As noted by Felix Goltz, research director at Scientific Beta and head of applied research at EDHEC Risk Institute, managers and index providers are finding factors that purportedly reap investment rewards; the findings, however, are based on proprietary studies that haven’t been replicated by anyone else.
“An often-cited analogy is to see factors as the ‘nutrients’ of investing,” the paper’s authors wrote. “Just like information on the nutrients in food products is relevant to consumers, information on the factor exposures of investment products is relevant to investors.”
Taking the analogy further, the authors argued that factors can’t be constructed arbitrarily, just as nutrients like protein or saturated fat can’t be defined in a proprietary way. But in the search for a secret performance sauce, managers are trying to define factors in different ways.
Aside from the limited, well-known set of known factors, the industry has claimed to have found many more that are far more complex, pointing to patterns in backtested information as proof of their effectiveness. From a statistical perspective, Goltz countered, researchers are bound to find something that works — but that doesn’t mean they actually will outperform.
“How reliable are these so-called proprietary factors?” he said. “And if you don’t have the same level of scrutiny applied to these proprietary factors, then you’re taking a higher level of risk.”
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