Hedge Funds, Smart Beta and Volatility Timing are Magically Delicious
Smart Beta Herd
As institutional investors start to feel a bit icky from hedge funds, a number of fee-conscious asset owners float toward smart beta or factor-based strategies. These rules-based strategies often use factors such as volatility, momentum, dividends and other non-market cap measures. Investment experts warn about the crowing effect on factors. Having a herd mentality in smart beta can be dangerous and lead to investment disappointment. The ideal moment to enter a smart beta strategy is contested, but some see when a factor begins to trend higher with a market rally an opportune time to jump in versus buying late into the factor performance cycle. Asset managers are also cashing in on smart beta such as WisdomTree, State Street Global Advisors and BlackRock. BlackRock witnessed US$ 152 billion in new assets flowing to mutual funds and exchange-traded funds in 2015. Not only institutional investors are driving the use of smart beta ETFs, but so called robo-advisors. This could lead to significant excesses in factor strategies.
Yale Professors Investigate Volatility Timing
This leads to my third bit, timing volatility which is a key element of market timing (aka make money). A research study conducted by Yale assistant professors of Finance Alan Moreira and Tyler Muir, called “Volatility Managed Portfolios” discovered that taking less risk when market volatility is high, can result in large positive alphas and boost Sharpe ratios by substantial amounts. The study finds that short-term and long-term investors can benefit from volatility timing and the returns would have a material impact on performance. Some parts of the study are quite obvious, portfolios that cashed out of equities before the global financial crash of 2008 and that came back after volatility dropped post-crisis, made substantial bits of money. Yes, some sovereign funds timed this quite well.
The views in this article are expressed by Michael Maduell.
Michael Maduell is President of the SWFI.
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