Many investors and advisors may not be aware of the hidden consequences of smart beta portfolios that use factor-only approaches but don’t consider concentration risks or the impact of turnover.
Parametric Portfolio Associates launched this summer a series of U.S. and international factor strategies aimed at tackling these hidden consequences.
Part of the firm’s “Custom Core” strategies, Parametric’s factor-based portfolios are constructed using active risk controls to deliver exposure to popular factors while managing risk, costs and unintended exposures.
The strategies are designed to be implemented in tax-efficient separate accounts with a minimum of $250,000.
Paul Bouchey, Parametric chief investment officer, recently discussed these two problems (turnover and unintended risks) and how Parametric is addressing them in its new strategies.
First up, the impact of excessive turnover leading to transaction costs and taxes.
“There’s always trading that has to happen in these smart beta and factor-based investing strategies,” Bouchey explained at a media event on Tuesday in New York. “That obviously comes with transaction costs, which can eat away into an investor’s return.”
For taxable investors especially, Bouchey said, trading costs can be huge.
“If you sell something that’s appreciated, you have to pay a capital gains tax,” he said. “It’s almost like upwards of half of your returns can go to the government. And if you’re talking about small equity returns to begin with and small extra excess returns from your strategy, this can completely destroy the value added.”
Bouchey called this a big problem, adding “I don’t think that’s been discussed enough in the industry.”