A new study has raised questions as to whether smart beta mutual funds, which are on course to reach $1 trillion in assets by the end of 2017, are as “smart as they claim to be,” according to a recent article in the Financial Times.
The article quotes University of Finland finance professor Antti Suhonen, who led the research, from his report (published in May): “Investing in smart beta does require good investor education, due diligence, monitoring of the investment and, most importantly, a strategic and realistic setting of investment objectives for the strategies.” Suhonen’s study examined 215 strategies developed by investment banks across five asset classes.
The article also cites a warning by Rob Arnott, one of smart beta’s pioneers, who wrote last year that these investment strategies—which invest based on so-called factors (i.e. P/E ratio or level of dividend payments) rather than simply on market capitalization–could go “horribly wrong.”
A big part of the problem, the article argues, is that smart beta strategies use “back-testing” to evaluate how factors would perform. In his report, Professor Suhonen cites concerns regarding data-mining—”when companies keep testing different figures to obtain a desired result.” Peter Sleep, portfolio manager at UK-based Seven Investment Management, says that investors should see back-testing reports as marketing documents, adding, “Computer power is cheap, and it is easy to perform millions of back tests and find which one works best or looks best to clients.”