Over the years in articles such as Left Smarting and Smart thinking, so-called ‘smart beta’ investments – strategies that try to build on simple index-tracking products by focusing in on a specific factor, such as momentum or value – have not always been portrayed in the most favourable of lights, here on The Value Perspective.
It is not the idea of smart beta in itself that has led to our concerns so much as the way such strategies can exacerbate investors’ well-documented inability to judge when to buy into and sell out of markets. Still, when we read recently of the 2012 launch by Barclays of an exchange-traded product that uses one of our preferred metrics – the cyclically-adjusted price/earnings ratio or ‘CAPE’ – we admit our interest was piqued.
The CAPE ratio encapsulates the average earnings generated by a business, sector or market over the preceding 10 years, adjusted for inflation. While it does have its limitations – as we discussed in Only fools and bourses – the way the 10-year average helps smooth out the peaks and troughs of an economic cycle makes the CAPE ratio considerably more useful than many other financial metrics.
Quoting the prospectus, this ETF.com article said the Barclays product uses an index that incorporates the CAPE ratio “to assess equity market valuations of nine sectors on a monthly basis to identify the relatively undervalued sectors represented in the S&P 500”. It continued: “The index then selects the top four undervalued sectors that possess relatively stronger price momentum over the past 12 months and …”
Hang on a moment … “relatively stronger price momentum”? Here on The Value Perspective, we could not swear to having read every word ever written on the CAPE ratio but, in all the many words we have read on the subject, we have never come across any mention of price momentum. And bearing in mind that concept is about as far from value as it is possible to get, believe us – we would have remembered.
The ETF.com piece, which was written in October 2012, actually started by highlighting one of the biggest exchange-traded fund launches of the preceding 18 months – a smart-beta product “cherry-picking lower-volatility stocks that are part of the S&P 500”. Since coming to market in May 2011, the article said, the PowerShares S&P 500 Low Volatility Portfolio had attracted almost $2.5bn (£2bn) in assets.
In comparison, the Barclays fund raised $37m at launch and, four years on, has only grown to $41.4m in size, which may or may not have something to do with an expense ratio of 45 basis points. Either way, this fund’s brief history suggests, for one thing, smart beta strategies cannot replicate buying cheap stocks effectively and, for another, even if they could, most investors remain supremely indifferent to value.
Our view that, if most investors were interested in value, they would be better off entrusting their money on a medium to long-term view to genuinely active managers presumably goes without saying. So instead we will simply wonder whether, if Barclays could turn back time, it would choose to call the fund the Low Volatility CAPE Portfolio. Presumably investors would then have been tripping over each other to hand over their cash.