May 13, 2015

Smart Beta

“Management wants answers when we don’t trade with our peers.” This is a lyric from a song by the rock band Smart Beta.

Just kidding. But Smart Beta is as good a rock-band name as One Direction and each begets the other in the stock market. Because capital-markets globally have become variations on a barcode theme – call it one direction – investors are experimenting with ways to break away.

Just yesterday you could see a currency patina painting worldwide equities, with some Asian markets up equal to declines in European stocks. Then when US shares began trading, ours were both up and down, a sort of global convergence.  As currencies fluctuate, divergences spill into assets denominated by them, feeding short-term arbitrage. It’s still a pattern.

Back to the opening salvo, it’s a routine refrain: “My CEO wants to know why we’re down and our peers are up.”  Patterns vex not only IR folks trying to answer management but the scads of money entrusted to fund managers promising as they all do to “outperform the market.”

Enter Smart Beta.  Some call it “factor-driven investment,” others “strategic beta.” Beta in investment-speak defines comparative performance so smart beta implies better comparative performance. Beta 1.0 defines behavior for the whole market. Figures above or below 1.0 signal a security’s historical tendency to be more or less volatile than broad measures.

We get all that, right? It’s outdated. Beta no longer captures volatility well since any widely traded stock will have thousands of daily prices, the final one the closing price. We prefer to measure intraday volatility.

And our hunt for better metrics is like quantitative effort to break from the Blackrock/Vanguard pack. That’s smart beta. Vanguard itself is toying with the concept through funds like the Vanguard Dividend Appreciation ETF.  Founder Jack Bogle nonetheless scoffs, telling CNBC’s Tom Anderson in a March 2015 story, “Active managers are just trying to come back and say there is a better way to index, when they know damn well there isn’t a better way.”

Still, smart beta money has exploded, jumping 170% the last five years to $540 billion, easily the pack leader for growth in model-driven investing. A smart beta ETF might weight all positions in the S&P 500 equally rather than by market-capitalization, which can skew the index toward big components. Apple for instance at 4% of the index’s market-cap distends moves, great if you’re a manager hoping to mail it in with the least effort. Smart beta hopes for smarter.

And so smart beta becomes another reason for disparate performance in your shares versus peers or a broad measure. Say you have a higher return on equity than your peer group. A smart beta model could weight your shares with that criterion, leading to outperformance for you that management supposes is rational.

If you think IR has got it tough grasping for explanations, consider the investment community. Matthias Knab at UK hedge-fund tracker Opalesque wrote recently that academic research shows about two-thirds of stock returns cannot be explained by identifiable factors.

Smart beta is just one reason, but it’s something smart IR should know.  And there’s more. Sometimes, moves you cannot explain reflect supply/demand imbalances. If your sentiment is negative and your short-volumes low, the likelihood of a rebound is great: Any buying will hit limited supply and a lack of both competition and money heading the other way, leading shares to sharply outperform peers. It could be rational, but investors buying your peers similarly and there finding readier supply won’t see those shares move.

It could be bets. One reporting client last week had short volume of 63% that on results plunged to 46% in two days. That’s short-covering.  In another, everybody feared bad news beforehand (we measure that). Results relieved fears and forced speculators to cover bear bets. Shares soared 10%.

Now you might say, “Who cares? Our executives focus on the long-term.” Ah yes. But investors setting price are looking for, say, smart beta. If executives equate focusing on the long-term with a belief that long-term money will then set price, they will be laboring under the burden of a 1980s marketplace while investors pursue beta.  Or alpha.

Smart IR folks recognize that what makes something true isn’t whether we believe it or not.  Beta just is. Measure behaviors, and give better answers.

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