It happens all the time. A new strategy emerges from the obscure recesses of the research caverns and morphs into an ETF, mutual fund, or a separate account program. Or perhaps it’s outlined on an investor’s blog for all the world to see. Sometimes there are glowing reviews fueled by compelling back-tests. For the most successful strategies that spawn products, there are big inflows of assets. There’s usually plenty of hype too. But when you peel back the details and drill down into the core of the strategy du jour, you’ll typically find a familiar combination of variables: rebalancing with one or more factor tilts.
Product vendors trying to sell new funds don’t like to talk about this, but most of what passes as enlightened money management is linked rather closely with rebalancing the individual holdings back to a fixed-weight benchmark with a particular bias: small-cap and/or value stocks, to cite one of the more popular tilts. I bring this up not to disparage and dismiss active and quasi-active strategies. But I think it’s useful to remind ourselves of what’s usually driving performance in a bid to recognize when “smart” investing is less than it appears.
A simple example is comparing the standard S&P 500 stock market index to an equal-weighted strategy that’s applied to the same pool of companies. As a cap-weighted benchmark, the basic S&P index is commonly described as a “passive” measure of US equities. To some extent that’s true, particularly with regards to rebalancing: there is none. Granted, individual companies come and go in this index for a variety of reasons through time, but let’s ignore that for now. When you buy an S&P 500 ETF, you’re purchasing a strategy with a specific set of rules: no rebalancing, which promotes large-cap and growth tilts.
By contrast, an equal-weighted S&P 500 ETF—the Guggenheim S&P 500 Equal Weight (RSP), for instance—has a rebalancing regimen that periodically moves the weights for each of the individual names back to something approximating a 1/500 allocation. In turn, that simple strategy promotes small-cap and value tilts—tilts that have delivered a handsome premium in recent years over the standard S&P index, by the way. In any case, these tilts are conspicuous mostly in relative terms—relative to the cap-weighted profile of the standard S&P 500 index. The point is that by adding a rebalancing strategy to a portfolio of S&P stocks, the strategy generates different results.
Some clever managers (and their marketing departments) repackage rebalancing and the associated factor tilts as their own home-grown strategies. The rebranding goes by any number of labels, and there’s usually a higher fee and perhaps bold claims of offering something previously unavailable. (Modesty was never one of Wall Street’s strong points.) And just to be clear, this rebranding and repackaging (R&R) knows no bounds in the money game. Repurposing a variation of the S&P equal weight strategy as something new and improved is merely the tip of the financial iceberg. Virtually all asset classes witness some form of R&R. You’ll also find this activity in the growing field of multi-asset class products.
The good news is that it’s usually easy to identify the closet indexers. Bill Bernstein, a financial advisor, wrote a great primer on factor analysis a number of years ago–“Roll Your Own”–and the basic lesson still resonates. Regressing a fund’s returns against a set of plain-vanilla benchmarks reveals what’s driving the results. Not surprisingly, this type of quantitative investigation tends to unmask the rascals trying to overcharge and oversell simple beta blends. The message is that you should “Roll Your Own” before you leap into the latest new new thing.
Recognizing the financial industry’s habits on this front raises two key issues for investors (individuals as well as institutions) when surveying the landscape of ETFs and mutual funds and investment strategies generally:
• Look under the hood. If you’re intent on buying a fund that moves beyond a simple strategy of running a market-value-weighted portfolio–i.e., standard betas–make sure that you understand what you’re buying and why you’re buying it. In the case of an equal-weighted S&P 500 fund, the contrast with the standard S&P 500 strategy is transparent. But that’s not always the case with some “innovative” strategies. By combining a variety of factor tilts with a form of rebalancing, it’s easy to create the appearance of an innovation that’s really just an old idea with a new marketing spin. Nonetheless, if you’re going to pay more for R&R, which is almost always the case, you should be clear on why you’ve made this choice. Sometimes, perhaps most of the time, the R&R under scrutiny isn’t worth the higher fee because a) you can replicate the strategy less expensively with a mix of standard betas; or b) the underlying R&R strategy is flawed in some way. As a quick, albeit ridiculous and extreme example, there’d be no point in paying 100 basis points for a strategy that holds the smallest 25% of S&P 500 companies. You’d be better off with one of the standard small-cap or mid-cap ETFs that do something comparable and charge far less for the service.
• Can you do it yourself? Quite a lot of R&R is simply blending a mix of well-known factor tilts and marrying it to a rebalancing strategy. There’s nothing wrong with that. In fact, it’s the bread and butter of enlightened investing generally. The question is whether you should do the mixing yourself? The answer varies, depending on the investor, the strategy and the extra fee you’ll pay if someone else is running the show. No one should underestimate the value of hiring a financial advisor to manage your portfolio, or holding an intelligently designed ETF that seeks to add value over a plain-vanilla index fund or tap into a beta that’s hard to manage by yourself. But the details matter and so it’s crucial to think through why you should outsource the investment process.
The bottom line is that quite a lot of what appears to be a good deal in the exploding list of “enlightened” strategies in the land of ETFs and mutual funds is just an excus to charge more for something that can be accessed less expensively and more efficiently through other means. There are exceptions, of course, and those exceptions are worth every additional penny charged. Unfortunately, finding the exceptions takes work. Par for the course in a world that’s overflowing with high-priced mediocrity that’s masquerading as creative and pioneering portfolio design.
This piece is cross-posted from The Capital Spectator with permission.