Learning to Love Smart Beta

CalPERS, with an AUM of $300 billion, has 18% of its equity portfolio in smart beta products. Similar stories are told of UK pensions. One is cutting out its hedge fund investment and putting it into smart beta. Hsu said the thinking is, “Why pay a higher fee when you can replace with lower cost product and get the same exposure?”

With this tidal wave of acceptance, the question, Hsu said, “is no longer should I [use smart beta products], but when do I get in?”

Hsu detailed alpha decomposition, showing its split into two parts: cyclical and persistent. He noted persistent performance is “most related to true skill,” but cyclical is both dramatically positive and negative and washes itself out, but it’s what dominates returns and manager experience.

His conclusion was that so many decisions and so much advice are trend chasing in nature, regardless of advisor or investor experience. “It’s intuitive to you…. That means investor outcome is about 200 to 400 basis points behind what managers report because almost all investors time, and time aggressively.”

Another example he noted was, over a three-year period, it was normal to keep the successful managers and cut out the loser managers, but in the longer term, it was the ‘loser’ managers who did as much as 250 basis points better than ones who were successful over that shorter period.

The same thing goes for stocks. People buy what’s hot, even if it’s expensive. “You need to be more countercyclical; take profit if a particular manager or style factor has been successful and rebalance it into what has been less successful,” Hsu said. “Short-term success has nothing to do with long term skill of manager or value…it is mean reverting to cyclical boom or bust.”

He urged investment skepticism, saying, “Recognize that we are always timing, so pay attention to decisions you make  when reviewing managers, new products. Realize 50% is timing!”

— Related on ThinkAdvisor:

• The Rise of Factor-Based Investing, aka Smart Beta, Finds Favor
• Asset Managers Gobble Up Smart Beta Firms