The Risk of Investing in "Smart Beta" Funds

Writing in the Wall Street Journal, Jason Zweig cautions readers against blindly investing in popular “smart beta” funds. He notes that a recent Research Affiliates study suggests “their low risk in the past may lead to higher risk in the future.” These “smart beta” funds are “backed by research purporting to show [they] ha[ve] beaten the market.” Assets invested in such funds has tripled over five years, to a total of $565 billion in 2015.  Robert Arnott of Research Affiliates says that “much of the money is chasing recent past performance.” For example, some funds are based on “low volatility” stocks, which were “about half as expensive as the market overall” from the 1970s to early 2000s, but are now roughly 20% more expensive than other stocks. Arnott notes that, in the case of a smart beta fund based on low-volatility stocks, “all the value they’ve added comes from getting more expensive.” It is far from clear whether such performance can be maintained in various types of smart beta funds. Further, as Zweig writes, there is ample reason in the psychological literature to question whether studies underlying smart beta funds “may find positive results by chance alone.” As Marcos Lopez de Prado of Guggenheim Partners puts it, there is a good chance that increasing data access via computers allows development of investment strategies based on “statistical flukes without theoretical support” and this may be the case with many smart beta funds.