Smart beta ‘could go horribly wrong’

Smart beta, one of the most popular investment strategies of the past 12 months, could go “horribly wrong” and leave investors nursing large-scale losses, according to one of the pioneers of the concept.

Rob Arnott, chairman and chief executive of Research Affiliates, the US company that developed some of the world’s first smart beta indices, has warned that the soaring popularity of these strategies is likely to lead to a severe fall in investment performance. “In the next three to five years, I expect [some smart beta investors] will end up very disappointed,” he said.

His company published a report last week, suggesting some smart beta funds could go “horribly wrong” for investors.

Mr Arnott added: “I thought the growth in smart beta was a good thing. Now when I see product proliferation in areas that I think are unwise and that are putting people at risk of performance chasing, that growth ceases to be a good thing.”

Asset managers, including BlackRock, Legg Mason and Amundi, have launched a number of smart beta funds, which act as a halfway house between active and passive management, over the past five years.

Assets under management in smart-beta strategies have ballooned from $103 billion in 2008 to $616 billion in 2015, according toMorningstar, the data provider.

These strategies take a basic passive investment strategy but tweak it to generate above-market returns, for example by excluding stocks with the most volatility over previous periods.

The strategies are often tested by looking at how an idea such as low volatility would have worked in previous years.

Research Affiliates said that many smart beta strategies outperformed the market because their underlying stocks became more expensive, not because of the factors the indices claimed generated strong performance.

Mr Arnott added that “performance chasing”, rather than investing fundamentally, could have dire consequences. “If you buy what has gone up just because it has gone up, you are buying for reasons that have nothing to do with valuations and run the risk of buying at the top of a bubble,” he said.