Smart Beta or Incidental Alpha?
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives
Enormous amounts of money are being invested on the assumption that algorithms can consistently identify security mispricings. I estimate that more than $1 trillion is currently committed to smart-beta products utilizing quantitative, factor-based approaches.
Smart beta’s allure is easy to grasp. In addition to offering investors the prospect of above-market returns, it enables asset managers to essentially automate alpha by replacing an army of analysts with an algorithm tweaked by a team of tech-sperts. For an industry in constant pursuit of scale, this is the Holy Grail.
But will it deliver? How likely it is that smart beta proves to be, well… smart?
Excess investment returns are achieved by capturing the difference between the current price of a security and its intrinsic value. As the name suggests, “quant” funds believe that they can consistently identify mispricings by subjecting information to quantitative analysis.
The thing is, numbers alone are dangerously misleading.
For example, what does the P/E ratio tell you about a company and whether it is over- or underpriced? Nothing. Without an in-depth understanding of the nature and quality of the “E,” the ratio is meaningless. The same holds for price-to-sales/cash flow/book value, etc. The relevance of all of these ratios is dictated by the quality of the denominator, which cannot be assessed in purely quantitative terms.
If you were to make a list of what is most important to understand about a company, subjects such as culture and competitive advantage would be at the top of the list (if that doesn’t seem self-evident, try finding a great company with a lousy culture and no moat). What do numbers alone tell you about the nature of a company’s culture or competitive advantage? For example, a firm’s return on invested capital may provide some insight into the latter, but it also overlooks an abundance of critical information. In late 2007, did any of Nokia’s financials indicate that its phone business was about to be devoured by Apple’s iOS and Google’s Android mobile operating systems?