This sounds highly attractive on the face of it, offering above-average returns and below-average management costs.
However, Research Affiliates in the US has recently done some excellent work examining the effectiveness of many smart beta factors. Its analysis has uncovered some fascinating conclusions around the way that earlier studies have been distorted by factor-valuation changes. Several smart beta strategies may therefore not be as powerful as the back testing indicates.
The firm’s work also considers the likely implementation costs and demonstrates that dealing charges can materially eat into the expected outperformance of some of these strategies. Investors need to tread carefully when extrapolating past trends and looking at pro forma track records.
Passive strategies can act as an important tool for portfolio management purposes, but there are many pitfalls that await the unsuspecting investor.
Jason Broomer is head of investment at Square Mile Investment & Consulting
