It’s well established that most retail investors, and quite a few financial professionals, blunt their own returns by chasing returns – buying near peaks and selling into a bear market when they should be doing the opposite. Smart beta aims to avoid this problem by recognizing that most of us are terrible stock pickers and then taking the emotion out of investing by tacking close to the index, selling stocks that have recently outperformed and buying those that have dipped in price.

The usual assumption is that smart beta just plays counterparty to retail investors, but it turns out that the full picture is more complicated.

Fund flows follow the same procyclical pattern

To show how herd investing can ensnare fund managers (even ones who know better), Research Affiliates analysts John West and Ryan Larson analyzed the investment history of an unnamed value fund that has beaten the S&P 500 (INDEXSP:.INX) by 1.4% on an annualized basis over more twenty years. Just like investors like to buy hot stocks and sell ones that are losing value, the fund had its strongest inflows after performance peaked and strongest ouflows while pulling out of a trough.

value fund flows v performance 0514 Smart beta

Smart beta excess returns come from end investors, not funds

Smart beta strategies are not taking their 2% excess returns directly from this or any other financial intermediary,” write West and Larson. “Smart beta strategies are earning their value-added returns from end inves­tors whose procyclical behavior forces the manager to sell stocks in bad times (usually when they are at the bottom of a cycle and cheap) and buy stocks in good times (when these stocks have outper­formed and are expensive).”

Smart beta

In other words, core investors who stick with this value fund and others like it aren’t the ones who are losing to smart beta strategies. It’s the investors who move in and out of the fund at exactly the wrong times that give up the most value, giving smart beta and other contrarian strategies the chance to shine. That’s not to say fund aren’t impacted by this pro-cyclical bias (this is exactly why hedge funds lock up funds as much as they can get away with), but West and Larson believe that it’s still the end investor who falls behind.

Smart beta

As value strategies have become more popular, price dispersion has fallen sharply and finding cheap stocks has become more difficult, at least in the US. The same could happen to contrarian strategies, but West and Larson aren’t worried. They argue that the confirmation bias, overconfidence, and the need for social validation will provide them a steady stream of procyclical trades.

 

Also see: Chris Brightman on Smart Beta Basics