Smart beta ‘could go horribly wrong’

Rob Arnott, chairman and founder of Research Affiliates LLC, speaks at the Morningstar Investment Conference in Chicago, Illinois, U.S., on Thursday, June 24, 2010.
Tim Boyle | Bloomberg | Getty Images
Rob Arnott, chairman and founder of Research Affiliates LLC, speaks at the Morningstar Investment Conference in Chicago, Illinois, U.S., on Thursday, June 24, 2010.

Smart beta, one of the most popular investment strategies of the past 12 months, could go "horribly wrong" and leave investors nursing large-scale losses, according to one of the pioneers of the concept.

Rob Arnott, chairman and chief executive of Research Affiliates, the US company that developed some of the world's first smart beta indices, has warned that the soaring popularity of these strategies is likely to lead to a severe fall in investment performance. "In the next three to five years, I expect [some smart beta investors] will end up very disappointed," he said.

His company published a report last week, suggesting some smart beta funds could go "horribly wrong" for investors.

Mr Arnott added: "I thought the growth in smart beta was a good thing. Now when I see product proliferation in areas that I think are unwise and that are putting people at risk of performance chasing, that growth ceases to be a good thing."

Asset managers, including BlackRock, Legg Mason and Amundi, have launched a number of smart beta funds, which act as a halfway house between active and passive management, over the past five years.

Assets under management in smart-beta strategies have ballooned from $103 billion in 2008 to $616 billion in 2015, according to Morningstar, the data provider.

These strategies take a basic passive investment strategy but tweak it to generate above-market returns, for example by excluding stocks with the most volatility over previous periods.

The strategies are often tested by looking at how an idea such as low volatility would have worked in previous years.

Research Affiliates said that many smart beta strategies outperformed the market because their underlying stocks became more expensive, not because of the factors the indices claimed generated strong performance.

Mr Arnott added that "performance chasing", rather than investing fundamentally, could have dire consequences. "If you buy what has gone up just because it has gone up, you are buying for reasons that have nothing to do with valuations and run the risk of buying at the top of a bubble," he said.

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Andreas Utermann, co-head of Allianz Global Investors, the $477bn fund house, also warned earlier this month that smart beta does not necessarily benefit the investors who buy it. "Smart beta is neither smart nor beta," he said.

But Mr Arnott's comments were met with resistance from other smart beta providers.

Felix Goltz, research director at the Edhec Risk Institute, a research institution that has developed smart beta indices, said it was "well documented, both empirically and theoretically" that smart-beta strategies deliver outperformance in the long term.

Research Affiliates' fundamental equity indexation strategy, which weights stocks based on their underlying value, has underperformed over recent years relative to a cap-weighted benchmark, said Mr Goltz.

In contrast, many of the strategies that Research Affiliates called overpriced have outperformed, he added.

Fabio Cecutto, senior investment consultant at Willis Towers Watson, an influential investment consultancy, also played down concerns about smart beta strategies.

"Smart beta simplifies [asset allocation decisions] and lowers costs overall. As with every investment strategy, there are risks. [But] we are actively recommending it to clients," he said.