Why these ETFs should come with a health warning

Smart beta funds, which aim to deliver returns above a like-for-like index, come with risks that investors should not overlook, warns Tom Bailey.

Over meaningful time periods, why do some share prices rise and others fall? The answer is far from straightforward, as there are various factors at play, but one of the main ways that fund managers try to gain an edge is through weighting up the fundamentals: cash flow, return on assets, and the intrinsic value of a business. Qualitative analysis is also carried out, such as considering the track record of the management team that is at the helm.   

However, according to the theory of factor investing, shares that outperform usually have some underlying characteristic – or factor – in common responsible for their performance. Factor investing is about identifying those factors through looking at and ‘backtesting’ historical data and investing accordingly.

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Over the past 50 years academics have identified and backtested hundreds of so-called factors. One of the most popular is the 'momentum' factor, which assumes that stocks that have gone up in price lately will continue to do so in the future, for some time at least. Also popular is the 'value' factor, screening for shares trading at discounted values on the assumption that under-priced shares eventually recover.

Other popular factors include quality (low debt, stable earnings, strong governance) and size (small-cap stocks supposedly perform better), among others.

The exchange trade fund (ETF) industry has latched onto the concept, with various products launched in recent years. Unlike a traditional ETF or index fund these so-called 'smart beta' ETFs, do not pick shares by market capitalisation. Instead these funds apply a sophisticated screen to the index or market and pick shares that possess certain factors or characteristics. The aim is to try and deliver more than a mere mirror of the market, but at a lower cost than an active fund manager.

According to a new study by Research Affiliates, factor investing strategies are becoming increasing popular for good reason:

"They are transparent, offer exposure to widely agreed-upon sources of expected return, have low management costs and, with proper design, reasonable transaction costs."

However, the paper, titled 'Ignored Risks of Factor Investing', also cautions: "Investors too often ignore, and thus do not prepare for, the risks that come with factor investing."

One key risk is the misleading nature of backtesting. The paper notes:

"A factor may look good because it is good or because the historical record is randomly good."

The paper also adds that backtesting becomes potentially less useful the more popular a strategy gets. Results are based on historical data from a time "when little money was being committed to these factor-tilt strategies." However, the relatively recent influx of capital into certain factor strategies can diminish outperformance of a factor.

Backtesting can also provide skewed ideas of correlation between certain factors, meaning investors are often under the illusion that investing in a number of factors provides diversification and mitigates risk.

This is often based on historically low correlations between factors, convincing investors that should one factor fail to produce outperformance then others will. Research Affiliates notes:

"Frequently cited low historical correlations, especially derived from backtests can be very impressive."

However, this fails to appreciate the reality that correlations between factors are not constant over time, making historical data less reliable.

At the same time, changing market conditions can reverse the correlation between certain factors, the paper adds, particularly in the event of a severe downturn in the markets.

The paper also notes that investors also often make poor choices about when invest in a factor strategy. "Entering at the wrong time, or missing a few market turning points can mean the investor is ultimately a net loser in factor investor." The most notorious example of this is the value factor, which has been in a bear market for the past 11 years.

Particular types of factor investing also carry often underappreciated risk, the paper adds. For instance, investors often underestimate the trading costs that come with the momentum style of investing.

Smart Beta ETFs: Look under the bonnet

When considering a smart beta ETF tread carefully, as there are a wide range of different strategies and some are more 'active' than others when constructing the screen of companies it will track. Some smart beta income funds, for example, will simply weight towards the highest yielding dividend companies in an index. Others, though, will also screen for certain company fundamentals, such as high profitability and superior business models.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.