Your Complete Guide to Index Investing with Dan Bortolotti

The Next Smart Beta Revolution

2018-05-29T21:47:40+00:00April 1st, 2016|Categories: New products, Smart beta|Tags: , |39 Comments

{Note: This post was an April Fool’s joke!]

As the ETF industry in Canada matures, more and more providers are moving away from traditional cap-weighted index funds in favour of more exotic strategies, which have been lumped together under the label smart beta. The goal is to build indexes that will deliver excess returns by adding more exposure to stocks with specific characteristics, known as factors.

For example, small cap stocks in the U.S. beat the S&P 500 by almost 2% a year from 1926 through 2012  (the size factor), while stocks with a low price-to-book ratio outperformed by a similar amount (the value factor). More recent evidence has revealed other factors, such as momentum and profitability. Now a group of academics has discovered a way to combine all of these factors into a single strategy that will revolutionize the way we invest.

The researchers have not yet published their findings, but I recently had a chance to interview the group’s leader, Dr. Molti Fattore, professor of financial engineering at the University of Milan. “It’s really very simple,” he explains. “We’ve known for a long time that the various factors can boost returns by a percentage point or two compared with the broad markets. What we’ve done is layer all of these factors on top of each other—like a factor lasagna.”

Of course, multi-factor funds are not new. Dimensional Fund Advisors have been running them for 30-plus years, combining exposure to small caps, value stocks, and companies with the highest profitability. More recently, iShares launched a family of FactorSelect ETFs based on similar strategies. But Fattore argues that his group has taken this idea to the next level.

“These other funds are totally inferior,” he scoffs. “Yes, they combine several of the factors, but the premiums clash with each other—it’s like pairing Chardonnay with chili. Our research has discovered a way to capture all of them simultaneously. So if the small-cap premium is 2% and the value premium is 2%, we will outperform by 4% before fees. Once you add screens for momentum, profitability, and the others, each one increases returns incrementally. It’s a very powerful model.”

Rigorous back-testing

If you’re skeptical, you should be. I was too, until Dr. Fattore showed me his back-tested results. He and his team ran simulations for 20,000 randomly generated multi-factor strategies using 60 years of data. Fattore and his team simply picked the one with the best results, removed the worst years from the sample so the results looked even better, and then came up with a compelling story about why the strategy should work in the future. “This was a genuine team effort,” he enthuses. “It’s not a simple matter to pull off this kind of data mining: it takes a lot of PhDs to do it properly.”

Fattore and his colleagues are now looking for ways to turn their research into an index that can be licensed by an ETF with a target fee of 0.75%. While they wait for Vanguard and iShares to return their calls, Fattore says the team is busy with the marketing plan. “We’ve already patented the name Beta Strategies and the ticker symbol BS.”