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Market Digest          
2.17.16          
Just How Smart are Smart Beta Funds?
 
Smart Beta describes an investment style where a manager follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. These funds effectively straddle the worlds of active and passive investing; they're actively designed to focus on some factor such as book value, dividend payouts or sales growth. But the strategy is passively implemented according to the rules outlined in their models.  

The increased popularity of Smart Beta is born out of the fact that active management has not been that successful of late, and investors are searching for risk management, diversification and enhanced risk-adjusted returns above traditional indices for a lower fee.

A big advantage of smart beta funds over active managers is cost. But, a new report out of Research Affiliates in Newport Beach says, "Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive." 

Robert Arnott, chief executive of Research Affiliates, says, "Much of this money is just chasing recent past performance. The flood of new buyers has inflated prices, jacking up returns and attracting still more new buyers." Looking at a dozen smart-beta approaches, Research Affiliates found that nearly all were cheaper than the rest of the market a decade ago but now trade at premium prices.

Mr. Arnott says, and we agree, that investors should be particularly wary of strategies that have recently become richly priced - including many specializing in high-dividend, low-volatility and "high-quality," or robustly profitable, stocks.
MARKET UPDATE
Although US stocks staged a rally last Thursday and Friday, the major indices suffered another down week. Some familiar culprits weighed heavily on stocks: falling oil prices, monetary policy and concerns about China's economy. On the brighter side, economic reports were generally positive with job openings in December surging and jobless claims falling.

Equity Index Returns
Source: Yahoo! Finance 
ECONOMIC NEWS

> Treasury Strength: The 10-year Treasury yield has fallen by 0.6% over the past six weeks, a very rare occurrence. Going back 20 years, such a noteworthy yield decline over such a short period of time has occurred only 2% of the time. The figure below illustrates not only the rarity of such large yield declines, but also the significant events that pushed high-quality bond prices higher and yields lower. Recessions or global crises are the most frequent catalyst, although the current episode has no single driver. China growth fears, oil prices, sluggish US economic growth, and most recently, bank credit fears, have each played a role in driving Treasury strength.
  
10 Year Treasury Yield Declines by more than 0.5_

It can be helpful to analyze this data to see if history can be a guide for the future. The record over the last 20 years is fairly consistent, but two takeaways stand out:

  • Periods of extreme Treasury gains do not necessarily reverse over the short term. Performance slows but remains positive over subsequent 1- and 3-month periods. So even though Treasury strength is extreme, high-quality bonds generally hold onto the gains over the short term.
  • Investors often look for periods of extreme moves as a signal that a reversal may be at hand, but history shows that extreme moves lower in Treasury yields may persist over the short term. Over the longer-term 6- to 12-month horizon, risk assets have a history of a relatively strong recovery following such a drop.
 
Risk Assets See Strength Following Steep Drop in Treasury Yields
 
Only time will tell how markets react going forward, but based on history, the coming months may be kinder to markets than the previous few have been.
 
NEW MARKETS. NEW ADVICE.
New Market Wealth Management is dedicated to providing thoughtful research-based investment advice and forward thinking services. Combined, the Partners have over 70 years in the investment management business, providing advice to some of the wealthiest families and largest corporations, endowments and foundations in America.

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