2015 Client Letter: Smart Beta

Fellow Investors,

I hope each of you are having a wonderful start to 2015. It appears many of us in Virginia have a bit more winter on the horizon. We can only hope that much like the financial media, the predictions of the weather media miss the mark.

Our investment team recently had the opportunity to participate in a conference call hosted by Dr. Marlena Lee, Dimensional Fund Advisors (DFA) V.P. of Research. The objective was to identify potential value from an investment strategy many of you may be hearing about: Smart Beta. We felt this strategy deserved some attention as it becomes increasingly prevalent in the investment community. To summarize, Smart Beta strategies weigh securities by “fundamental factors in an attempt to outperform capitalization-weighted indices” (Lee, 2015). These fundamental factors may include: book equity, sales, cash flows, total assets, dividends, etc. Please click here for a review of Capitalization-Weighted Indexing and here for a Bloomberg summary on Smart Beta. Smart Beta is often associated with providing two value adds:

Reduced risk without sacrificing expected return

  1. Increased returns by selecting stocks based on perceived mispricing

As a refresher, four factors do a remarkable job of explaining expected returns and are the foundation of our investment strategy. These return dimensions are represented in the following graph:


Dr. Lee evaluated several Smart Beta strategies and routinely found that any perceived advantages of Smart Beta are the result of the strategy unintentionally targeting the dimensions of expected returns as described above. As an example, a dividend focused Smart Beta strategy may have outperformed because it accidentally targeted more “Value” companies, not because it actually held better dividend paying stocks. Smart Beta is yet another reminder that correlation is not causation.

It’s worth noting that some Smart Beta strategies, e.g. Momentum, produced higher expected returns in computer simulations. However, these models required large, and probably costly, trading techniques. “A strategy designed to outperform the market is only profitable if it can do so after costs” (Lee, 2015).

 Smart Beta has built momentum among investors in recent years. The finance industry does a wonderful job of coining terms to attract new investors while simultaneously communicating the message of differentiation and value. However, it’s our opinion that Smart Beta does not add significant value to our investors once properly evaluated. Further, any advantages found in modeling specific strategies are usually discounted when taking into consideration the sizeable trading and tax cost required to support the strategy. We will continue to focus on the various factors influencing return premiums while managing the cost of the investment process.

We would like to make available a detailed summary of this analysis completed by Akhtar Khan in our office. Please don’t hesitate to reach out to Akhtar or myself for a copy. We would be more than happy to provide it.

Stay warm and we wish all of you the best!

Jeffrey A. Hahn

Managing Director/CCO