In most professions, a success is a positive gain for society: a cured patient, a new building, a technological advance. With investment management, it's different. Assuming that we define investment success as outperforming a market index, winning can come only at the expense of someone else's loss.
As noted by the Nobel laureate William F. Sharpe in his 1991 article, " The Arithmetic of Active Management," it all comes down to simple math. The first assumption is that the market, as a whole, consists of the portfolios of all investors. It then follows that if some investors are beating the market, others must be lagging.
This is a classic zero-sum game. And it holds true not only for traditional active management, but for the new breed of " smart beta" indexes.
While there is no fully agreed-on definition of what constitutes a smart-beta index, a defining characteristic is that they use weighting schemes that differ from market-capitalization-based indexes. The S&P/TSX Composite, the S&P 500 and the MSCI EAFE market benchmarks are all examples of traditional market-cap-weighted indexes. Each security is held in proportion to its market cap, which is the stock price multiplied by the number of shares outstanding (usually adjusted to reflect the number of shares available for trading.)
In contrast, the portfolio weights of smart-beta indexes are based on other criteria such as fundamental measures of size or quantitative measures of risk. Among the growing number of smart-beta funds available in Canada are exchange-traded funds such as PowerShares FTSE RAFI Canadian Fundamental Index ( PXC) which replicates a fundamentally weighted index, and BMO Low Volatility Canadian Equity ETF ( ZLB) which replicates an index in which weights are inversely proportional to market sensitivity (beta).
In market-cap-weighted indexes, trading activity tends to be low unless securities are being added or removed from the index. There's no need to trade to maintain market-cap weights.
However, with smart-beta indexes, trades must be made to maintain the prescribed weights. Some shares of securities that rise in price need to be sold and additional shares of securities that fall in price need to be purchased. This pattern of selling winners and buying losers is called contrarian trading.
In a recent research paper, Research Affiliates founder Rob Arnott and three co-authors presented the results of a study of various smart-beta weighting schemes applied to U.S. and other equity markets. In addition to the smart-beta schemes, they created portfolios using their inverses.
For example, in addition to the standard low-volatility scheme of weighting each stock in inverse proportion to its historic volatility, they created a high-volatility portfolio in which each stock is weighted in direct proportion to its historic volatility. Then, just to make things even more interesting, they created equally weighted portfolios of stocks selected at random.
They found that all of these schemes -- smart beta, inverted smart beta and randomly selected portfolios -- outperformed market-cap weighted portfolios of the same stocks! So in the end, it is not the weighting scheme itself that matters, but rather the successful execution of a contrarian trading strategy.
As Arnott observed, there must also be "willing losers" on the other side of these contrarian trades.[1] If some investors are selling off their winners and buying up losers, there must be other investors making the opposite set of trades to accommodate them.
So who are these willing losers? As my Morningstar colleague Russel Kinnel has written: "We know that many individual investors suffer from poor timing and poor planning, whether they buy stocks or mutual funds. In both cases, investors frequently make the mistake of thinking that the recent past will repeat itself. As a result, they buy too late and sell too soon."
At Morningstar we quantify this phenomenon for funds by comparing a fund's official rate of return over a period of time (known as the time-weighted return) and what we call the "investor return." The latter is the dollar-weighted return based what the fund's net assets were during each month of the period.
Generally, investor returns trail the official returns. We view this as evidence that fund investors chase performance. The effect is particularly strong for highly volatile equity funds. As Kinnel explains, "In general, the more volatile a fund, the more likely it is that investors will be motivated by fear or greed."
Given the wide swings in investor sentiment, and given how well all price-insensitive weighting schemes performed in back tests, I conclude that the willing losers are those investors who habitually buy securities in response to price rises and sell in respond to price declines.
As long as these investors are in ample supply, there are opportunities for professional managers who follow contrarian strategies to take advantage. Investment products linked to smart-beta indexes provide a simple means of doing so.
This is not to say that all smart-beta products are created equal. Low costs are essential to their future success. In particular, the costs of rebalancing away from market-cap-based weights need to be kept low.
As smart-beta funds gain popularity, it's possible that the trades that they generate could drive up the prices of the stocks that they overweight and drive down the prices of those they underweight. Stocks of smaller companies and stocks that are more thinly traded would be especially prone to the impact of higher trading volumes.
It's also important that smart-beta strategies be scalable. That way, there are ample shares available for the funds to hold -- and for willing losers to sell.
[1] In a tribute to Jack Bogle in The Man in the Arena: Vanguard Founder John C. Bogle and His Lifelong Battle to Serve Investors First by Knut A. Rostad (John Wiley & Sons, 2013), Arnott says "If we depart from cap-weighted indexation, we do well to recognize that we can beat the market only if someone on the other side of our trades is a willing loser."
