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Fund Managers Use Machines, "Smart" Beta To Dupe Dumb Retail Investors
Active fund managers have figured out a way to combat the rather inconvenient fact that beating a passively managed index fund over time turns out to be exceptionally difficult, especially net of fees: build an algorithm that replicates your investment strategy, press “go”, then tell investors you’re indexing. This is called “smart beta” in the industry and, like any sophisticated-sounding strategy, it’s luring retail investors and bringing in billions. Here’s Bloomberg:
Few people have profited more from the so-called smart-beta craze than Tom Dorsey. A new exchange-traded fund that he runs using a century-old charting methods took in $1.2 billion last year. Then, in January, he sold his 22-person investment firm, Dorsey, Wright & Associates, to Nasdaq OMX Group for $225 million.
Dorsey calls himself a money manager, Bloomberg Markets will report in its April issue, but his methods are more robot designer. He says so himself, proudly. If Dorsey and his team got abducted from their Richmond, Virginia, office by aliens, their algorithms could keep picking investments for the firm’s new money magnet, the First Trust Dorsey Wright Focus 5 ETF, forever.
“Once a quarter, we press a button,’’ Dorsey says. The Focus 5 algorithm then generates a list of investments, and First Trust Portfolios, his partner company, executes them. Otherwise, they don’t meddle with the robot. “We just need someone to press the button.’’
It’s index investing with key twists, all of them rules-based, with no active management required. Most smart-beta funds track custom indexes. Some are simple variants of the Standard & Poor’s 500 Index and do what they say on the box. Others are hand-crafted and small batch, made by people with little more than a stock-filtering system and a dream.
So it’s index investing, only the index isn’t really an index, it’s a list of stocks generated by a machine and the machine is programmed to do what the fund manager would do if the fund manager were disciplined enough to follow his or her own advice all of the time. In other words, it’s not indexing at all — paradoxically, it’s active management on autopilot and advocates of traditional indexing think it’s nonsense. Here’s Jack Bogle via Bloomberg:
“Don’t mention smart beta in this office!’’
“I don’t even know what it means. Baloney. Marketing!’’
What it means is that fund managers can make a really compelling pitch to investors: “It’s the best of both worlds. These ETFs are smarter than ‘dumb’ traditional index funds, but they’re still passively managed.” While some of these funds follow what might be considered “plain vanilla” strategies (which makes you wonder why you wouldn’t just buy a traditional index fund), others try to be a bit “smarter” by shorting and (of course) employing leverage. As it turns out, some aren’t very smart at all:
Rick Ferri, founder of Portfolio Solutions in Troy, Michigan, says smart beta is a ploy for active managers to retake some of the billions lost to Bogle and his low-cost indexes. If an active manager has an investment strategy that shows positive returns over the past decade or so, and it can be encoded in an algorithm, he can call himself an indexer, charge higher fees for his secret sauce, and kick back and get rich, Ferri says. “Everything that used to be active management became fundamental indexing,’’ he says.
The Janus Velocity Tail Risk Hedged Large Cap ETF has many of the things that smart-beta critics such as Ferri love to hate. Started in June 2013, the fund returned 6.8 percent in 2014, compared with 13.7 percent for the S&P 500, even though it invests in S&P 500–tracking ETFs. It underperformed because it paid for derivatives that protected it from tail risk—the slim chance that something would go really wrong. That insurance lowered its risk, certainly, but the fund captured just 50 percent of the index’s return, after expenses. Those totaled 0.71 percent, or $71 on each $10,000, compared with 0.39 percent, or $39 per $10,000, for Arnott’s PowerShares FTSE RAFI. “They’re making really good juice on this,’’ Ferri says.
Better still, some of the funds barely trade, which means if the automaton that’s automatically buying and selling based on some strategy the manager dreamed up two decades ago won’t quit producing loses, it may be difficult for you to pry your money from its robotic hands:
Velocity Tail Risk doesn’t trade much either. Some days fewer than 1,000 shares change hands, making it harder for sellers to find buyers. Last year, the average difference between an offer to buy and an offer to sell was 0.31 percent, or 62 times the average spread in the SPDR S&P 500 ETF Trust, which closely tracks the index.
Much to the chagrin of the Jack Bogles of the world, smart beta funds look set to become increasingly pervasive. As Bloomberg notes, they now account for nearly 20% of the entire market for US-listed ETFs which means some $200 billion is now trading on autopilot, chasing who knows what based on a mishmash of esoteric strategies created by active managers who by virtue of their inability to outperform the dumbest strategy of all (simply buying an index), were driven nearly to extinction — and there’s limited liquidity. What could go wrong?
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Which bank will collapse next?
Credit Default Swaps Info:
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my roomate's step-mother makes $79 hourly on the laptop . She has been fired for 10 months but last month her pay was $18694 just working on the laptop for a few hours. see here... www.globe-report.com
If investors dont realize retail is dead and buried, "bridge for sale".
I have a small position I've held for years as 'buy and hold'. Every few weeks I get an "invitation" from Ameritradetm to try their new trading platforms. Can't hit the email/delete fast enough.
My pet CHIMP is a better investor than 98% fund managers
How much are his fees?
A few things that Vogel, Fama and the index clique badly wish you could forget
- In 1956-1969 there was two periods of near full tilt up market rips. Much of the wealth effect generated by stocks from the post-war reconstruction and new military technologies such as vac TV/tube systems and FM media content was leading to a rip roaring rally. Everyone argued that passive indexing, particularly investing in a small basket of closely held stocks, all large cap, all US focused would be the best way forward. It was argued by indexing guru's, a simple basket of 50 stocks, selected at random could outperform any market period.
- From 1969 to 1979; the average 'nifty fifty' passive index fund lost somewhere between 78 to 97% of its value, graded for market cap and sector weights.
- Given the passive nature, multiple volumes of share indexes were issued, creating an infinite volume of units "long" and available for shorting. Which led to a record collapse in valuations and multiples when many investors were faced with a sudden understanding that liquidity is a naturally draining mechanism from the system as coupons & losses evaporate monetary value (vs. Austrian which believes the system is self contained and cash out = M1).
- The average smart beta portfolio is just a iteration of the old 'direct manager' model, which as Warren Buffett or anyone will tell you was the original 'rats in the grainhouse' model.Whereby the volume of redemptions in these low fee, low trailer models tend to slip and slip further as they must meet redemptions as both 1, the passive index collapses by a scarcity of liquidity in both cash & underlying shares and 2. they need to track their redemption orders
In the 1969-74 period redemptions were weighted on monthly basis, and it was a disaster for retail and passive advisors as each rebalance, and as new index components were flushed out, led to further routes and front running the inbound order routes. For many employed in those unlucky corporates, this resulted in overleveraged pensions imploding, and multiple swaths of the baby boomer generation being locked out of the 'wealth effect' for 10 years, regardless on the dovish fed policy, thanks to defunct corporate all-in retirement schemes & negative NAV (ex-inflation) portfolios.
Many, including Berkshire will argue that an index which cherry picks the best, and merits from selection bias from limiting losses by a mechanical screen for market cap/growth (no different than what these smart funds do anyways) will outperform by coat tailing the 'next big thing', however what they fail to argue is for someone who invested amid any market peak or market non-trough, on average you require at least 25 years to get back to even ex-inflation from a bear rally. And that is overstating the fact, since over 80% of an index will turn over in a 10 year period. The chance of you returning to zero is practically zero, when you take into account the chance of selection bias and the 0% chance you will perfectly time a market bottom; unless it is so fucking obvious like 87, 93 or 08 where you have a reset.
ECB does not count as a timing in my view, for the same way Japan 98 was not a timing bottom.
Take that economic history for what you will. Vogel is long over his skis at this stage of the game, and I think given his pivot from ETF's, this is starting to dawn on him.
Badly.
How many times do we have to prove that 1) Funds are set up to make their sellers rich, not their investors and 2) Most of them show below average returns/
My dad gave me the best advise on this.
Him and my mum were living at my grandma's whilst in the process of buying their first house. My grandma lived up in the hills then and a mortgage broker drove up their in the snow to try and sell them an interest only mortgage. My dad answered the door told him the fact that he's driven up a hill in a blizzard goes to show who's benefitting more from the mortgage and closed the door.
If someone is eager to take your money or give you debt it's NEVER for your benefit.
The graphics left out the charts showing improved returns for some improved strategies.
Compare returs of PRF to SPY. Compare RSP returns to SPY.
Describing these strategies a Duping retail investors is nonsense.
The typical cap weighted index fund vastly overweights the highest market cap stocks.
The DJIA is the world's largest actively managed passive index, so why not create your own? I bet they're all cheap to run and with low internal operating costs, too, right? That's what I thought. Might as well just hang out the old 2-and-20 sign on them. One way or the other, that's probably about what you're gonna pay.
Yeah, but with computers you have something inanimate to blame it on, never mind that even the biggest computers are just glorified pocket calculators that can only do what they are told. This will not end well.
Scumbags, always have to check my watch after shaking thier hands, even walking by their office, you need to change your passwords.
So they only have to build a robot to push the button to make it even more advanced. I know that Jews are not allowed to push buttons on certain days so there could be a huge market for that.
The irony will be that it is likely the retail investors that will be out of the market when the AI trading wars kick in and send all the HFT lemmings off a cliff.
Squiggle alert : Peckerwood Securities has just issued a near term sell,...lol
Thank you for this. About a year ago I interviewed for a (computer) job with a company whose business seemed to involve this "smart beta" crap, and although I Googled it to death at the time, I was never able to figure out wtf they were talking about.
I thought, if someone said "Hey, design us a 'smart beta' wouldya?" what I might do is create some robot that, quarterly or weekly or annually, did a big data reduction on the market, ranked the sectors, and adjusted holdings. I have no particular reason for thinking this would work, but at least it would do *something*. Only, that's NOT what this company was doing. They were doing what your post here suggests, doing whatever, calling it "smart beta", and as long as their choices beat the market people paid them to keep doing it. Good work if you can get it.
I didn't get the job, bit of mutual decision, unfortunately, they seemed to have money to burn.
It's all modeling and the model is only as good as its input. The best market out there is squishy and the worst is plain old cooked and chaos theory is ignored. That said I do have friends who have made buttloads of money programming on Wall St.....
I know people who've made a buttload of cash at the dogs. Gambling is gambling.
Except at one local track that was so rigged the only bookies who'd accept bets were the ones fixing the races. Now what does that remind me of...
It's not gambling if you set and control the odds and computers are perfect for the job.....
"There's a mark born every minute, and one to trim 'em and one to knock 'em".
Sure, they all have different strategies to make money, but let's examine this from the other end of the timeline. They also have a strategy to get out when the big one hits. There's unlimited opportunities when it comes to offense, but there's very few when it comes to defense, you either amputate and take your losses, or sell down over time, ride it out or try to pick up bargains. Ignoring insurance in the form of derivatives, that's four, exactly FOUR strategies that can be coded into these algos. The problem is there won't be liquidity for any of these strategies, and the bodies will stack up at these four exits like victims in a restaurant fire.
When the big one hits, the markets will limit down in fractions of a second. Only the quickest of co-located cronnies will get off their trades. Rinse and repeat, until all the big banks get what they want, and THEN the fund managers will gain access to drive prices to the bottom and create bargains for the big banks.
Tyler,
While I agree with your assessment that the proliferation of these smart-beta robots isn't a good thing, and that its troubling how they've become such a large part of total ETF value, I'm curious how you recommend an active manager generate alpha in this macro environment?
We have central banks buying tens of billions of assets a month, when we see such giant balance sheets being put to work...it stands to reason that the indexes these passively-managed funds track will appreciate significantly. As a fund manager, how are you supposed to do some security selection if so many asset classes are highly correlated and moving almost in lockstep upward?
Granted, there are definitely opportunities and mispricings out there. But years of QE has crushed asset dispersion, I mean its so correlated now that we have the media talking about how a given trading day is "risk on" or "risk off". I disagree with this smart-beta crap, but I don't think its that easy to generate any alpha when you enormous central bank balance sheets diving into the market and swallowing up anything in its way.
I, for one, welcome our new robot overlords.
Smart beta falls on a spectrum between index investing and algorithmic trading. The biggest issues I see are fees and spreads. If these funds don't attract many assets, then it will be harder for the manager to beat the vanilla index. Also if they have less AUM then these things will be subject to big volatility.
But bots can build better bots that can skim the markets, maybe netting is a better word. I'd be wary of bots building other bots with the full intention to manipulate the building of other bots years to come.
But bots can do what we do and so then what we do isn't really valuable any longer so it makes you wonder why the bots would even want to do what we do and then corner the markets, and then corner the future markets (not futures since the bots already cornered those before the next generation of bots.)
It's just a matter of time before some of this money says enough and starts looking to alternative investments: real estate, businesses, stuff they can control.
Or not. The refrain of the retail creed has always been "over the long term"...