“The restaurant is so crowded nobody goes there anymore.” Attributed to Yogi Berra
In 1998 and 1999, tech stocks were the largest sector in the S&P 500 by market cap. The tech sector accounted for a whopping 29.2% of the popular index in 1999, so when tech stocks began to collapse in 2000, their demise had an inordinate effect on the S&P 500.
Financial stocks were the largest S&P 500 sector in 2001, accounting for 17.8% of the index. While these stocks also led the pack from 1995 through 1997, in 1995 the sector accounted for just 13.1% of the index. By 2006, financials represented 22.3% of the total market cap of the S&P 500. (For those in need of a dose of nostalgia, Industrials were the largest sector in 1990 at 13.6%.)1
Financials were the worst performing sector in 2007 and 2008. So by March 2009 financial stocks represented just 11.2% of S&P 500.
We suspect that most investors buying S&P 500 indexes in 2000 and 2007 were seeking a diversified portfolio of blue chip companies. What they got was an index overweight in expensive tech and financial stocks.
Although interest in passive investing - investing in a predetermined list of stocks - grew rapidly during both the tech bubble and the financial crisis, some investors began to doubt the wisdom of buying a market cap weighted index. By definition, when an index is weighted by market cap, the more expensive a stock or sector becomes, the higher its weighting in the index. To avoid this aspect of passive investing, investors became increasingly interested in products that offered equal-weighted exposure to an index.
Then two blinks later, smart beta became the Next Big Thing.
Smart beta means different things to different investors. Often these approaches fall into the category of strategy-based or factor-based smart beta. Strategy-based approaches often weight the securities in the index equally, or by something other than market value. These weights could be based on cash flow, revenues, dividends or book value. A smart beta approach that weights by book value, for example, isn’t seeking only value stocks, it is merely weighting the stocks in an index based upon the book value of the companies.
Factor based approaches, however, do tend to pursue stocks with particular characteristics. The most common seem to be value, momentum, quality and low-volatility. A smart beta value strategy might select an index and invest only in the cheapest 30% of those companies – as defined by a particular valuation metric. A low volatility strategy might invest in the 30% of stocks with the lowest volatility over a certain period. Each smart beta strategy is expected to outperform its broader index given the performance history of such stocks in the past.
And guess who wants to own these smart stocks destined to perform the best? Nearly everyone. Assets are flooding into smart beta funds, and new funds are popping up like relatives of a lottery Powerball winner. According to the Wall Street Journal, smart beta fund assets tripled from 2010 to 2015, reaching $565 billion at year end.2 The concept continues to win converts. According to a recent industry study, 59% of institutional investors who already own smart beta investments plan to increase their exposure over the next year.3
Ironically, (or perhaps we should say, “Naturally”) smart beta’s success may serve as a headwind for future performance. This is not an unreasonable assumption. As more investors pursue certain characteristics, the more expensive stocks with those characteristics become. High priced stocks can be risky since earnings disappointments can turn a setback into a freefall. Further, even if things go well, high valuations can act as a headwind for longer term total returns.
A group called Research Affiliates has taken a look at the enthusiasm for smart beta strategies and they are concerned. Research Affiliates has credibility here as they have been at the forefront of developing smart beta strategies for years. Yet, according to their research, a number of smart beta approaches have become expensive as investors pile into stocks with popular characteristics. Recently they argued that some smart beta strategies are so expensive that long term returns will disappoint investors, despite their historic attributes.
For example, in a February commentary with the not so subtle title of “How Can ‘Smart Beta’ Go Horribly Wrong?” the group argues that low volatility stocks are trading at high valuations based on data going back to 1967. Further, when low volatility stocks were this expensive in the past, subsequent 5-year performance suffered.4
Long time investors will remember that before the smart beta options of low-volatility, equal weighting, low beta or momentum there was growth and there was value. Value managers liked cheap stocks on the mend, and wouldn’t mind if you bought them lunch. Growth managers liked earnings increases and wore fashionable suits. Investors chose either or both, understanding that growth or value could be out of favor for long periods. And what determined the subsequent performance of each strategy? The valuation at time of investment played no small role.
We don’t have an opinion on how, if, or when smart beta strategies should be implemented. But we have been around long enough to see investors rush into strategies that perform well, then deliver disappointing performance. (See FANG stocks, 2015.)
For example, the data produced by Research Affiliates reveals that “Quality” stocks have generated good relative performance of late, but (not surprisingly) have become more expensive. We certainly have no objection to investing in quality stocks and have no doubt that a quality bias will perform well over time. But valuation should never be ignored as investors in the Nifty Fifty stocks of the early 1970s discovered. Because these stocks become wildly expensive, so-called “quality” underperformed for more than a decade. (For more information on the infatuation with “one decision stocks” see our January article on this topic.) That seems to be the concern of Research Affiliates: Today’s smart beta success will impede future performance.
As dividend investors, we take comfort in understanding that a significant portion of expected total return (dividend income) is determined by management and how much we are willing to pay for a stock. That leaves a smaller portion of return to be determined by other investors (capital gains), and what strategy is in favor at the moment, smart or otherwise.
1 Bespoke Investment Group S&P 500 Sector Weightings.
2 “Chasing hot returns in ‘smart-beta’ funds can be a dumb idea,” The Wall Street Journal, Jason Zweig, 2/12/16.
3 “Smart-beta funds take center stage,” ETF Trends, Tom Lyon, 2/2/16.
4 “How ‘smart beta’ can go horribly wrong,” Research Affiliates commentary, February 2016.
