The "Dr Jekyll and Mr Hyde" syndrome
When Alan Greenspan spoke of "market exuberance" (i.e. the lightning-fast mood swings from optimism to an investment bubble popping) wasn’t he referring to what we could call a "Dr Jekyll and Mr Hyde" syndrome?
This duality in finance is clearly visible between the bulls and the bears, the pro-cyclicals and the contrarians, the risk-ons and the risk-offs. The most traditional compromise between the two profiles consists of diversifying one’s portfolio across many different asset classes (money market/bonds/equities/alternative markets), then by regions (generally in equities or government bonds of one’s home country, then their own continent before finally opening the investment horizon up to the rest of the world). According to Nobel Prize winner Harry Markowitz, who developed the CAPM model, each asset class is defined by a benchmark, generally weighted by market cap or by issuance.
THEAM offers investment solutions across a broad spectrum of underlying assets (equities, bonds, commodities, volatility, currencies...) through an extensive range of investment styles, from pure Beta to Alpha.
This compromise leads to some surprising behaviour. If we take a look at bonds, for instance, plummeting yields on government bonds compelled many investors to switch to corporate bonds, high yield bonds and even emerging debt in local currency in the quest for yield. These same investors, however, remain strategically or tactically underweight on equities, as the asset class has been deemed too risky, an opinion that has been borne out in the various crises.
However, between a multinational in the utilities sector, where the stock is valued almost solely on its intrinsic return, and EM debt, countries with a less-than-solid structure, are we sure about our risk assessment?
How to extricate the markets from this situation?
Academic research has taken a close look at the interaction between emotions and rationality in human decisions.
On this subject, Nobel Prize winner Daniel Kahneman studied the way in which the human brain is wired to think in one of two ways: one that is fast but often wrong (Mr Hyde) and a second that is slower but more rational (Dr Jekyll).
Shifting our focus to finance in particular, James Montier’s work on behavioural finance explained in large part the most visible market biases. His findings have focused on topics including overconfidence in one’s ability to outperform the market, the belief that improbable events will materialise and a skewed vision of the economic reality. These mindsets have visible effects on the markets, such as the low volatility anomaly (when stocks with the lowest risk outperform the market), the popularity of value strategies (cheap stocks outperform) and momentum strategies (rising stocks will continue to increase).
Other researchers have analysed, sometimes during their entire professional careers, more specific aspects of these mindsets and their effects. Over a span of nearly forty years, the professor Robert Haugen analysed the low volatility anomaly.
These theories are available to the general public free-of-charge, are incredibly interesting and are convincing, but sadly, they have failed to sway behaviour. Notable exceptions exist, however, with certain particularly progressive institutional investors. In the Financial Times published on 27 February 2012, a Danish pension fund took the time to describe the internal revolution that consisted, over a period of two years, of replacing the approach by asset class and region with a comprehensive approach focused on risk premium (equities, liquidity premium and other factors i.e. low volatility, value, momentum).
It is therefore possible to alter investment behaviour, but it takes time to change people’s mindset. Investors must realise that portfolios should focus on: steering risk and not managing returns; on investment profiles not stock-picking; and that a benchmark is not just a yardstick but also a source of performance. This is what needs to be done before we can truly reconcile the comprehensive approach between the asset classes and the approach within asset classes, by moving beyond the Dr Jekyll and Mr Hyde dichotomy.
Where does Smart Beta fit in?
The term smart beta is difficult to define, because it comprises a wide array of systematic, i.e. algorithmic, strategies. The term is in fashion; everyone has jumped on the bandwagon in hopes of riding the wave. Some have even dubbed it a "new asset class" and are searching to construct a benchmark for it...this is absurd. In fact, these systematic strategies are all active, in the sense that they make clear and different exposure choices. They all, therefore, have different risk and return profiles. Comparing them with a benchmark would not make any sense.
The main point these smart beta strategies have in common is that they reject traditional benchmarks, i.e. benchmarks that are weighted by capitalisation, which is the predominant way of thinking (CAPM). This point is easy to accept, because even a simple strategy, like equal weighting, readily shows its capacity to reduce risk while increasing an equity investment’s return, demonstrating along the way that it’s not hard for a manager - even a human one - to beat the traditional benchmarks. Is, however, an equal weighting investment "smart"? This is doubtful, if we allow that it also overweights certain themes, whatever they may be, that are represented by a large number of underlyings. As an investor, for instance, do I really want to be exposed to as many Greek banks as there are on the market?
Other strategies, such as the RAFI indices, are founded on fundamental criteria (number of employees, size of balance sheet, etc.) to set the weightings of stocks in the portfolio. This leads to a clear value bias. There are yet still other strategies that we could call "risk-based", using risk measures for defining an "optimal" portfolio against a given backdrop. This is the case with Equal Risk Contribution (a.k.a. Risk Parity), minimum variance strategies, maximum diversification or Edhec indices. Lastly, theme-based strategies should also be included, similar to thematic indices, to play on themes separately such as quality, momentum or certain sub-themes like value strategies, targeting high dividends. We have also seen that some fund designers have such little faith in the themes they launch that they simultaneously create another product on the theme that is forbidden in order to hedge the original theme!
This is a shame, because - beyond the "smart beta" catch-phrase - an approach consisting of exposing a fund to reasonable risk factors instead of stocks or fund managers via traditional benchmarks, is definitely a new way to invest.
