What is Smart Beta?

You’ve undoubtedly heard this term, used to describe a certain type of investment that is becoming increasingly popular. What does it mean? And if these investments are “smart,” does that mean that the others are “dumb?”

So-called “smart beta” investing is a bit of an active/passive hybrid methodology. Traditional passive investments are typically replicas of well-known market capitalization-weighted indices, like the S&P 500. A market cap-weighted ETF holds each company in the index according to its size in the index, which can be calculated by multiplying a company’s outstanding shares by the current market price of one share. While this provides broad market diversification at a very low cost, one drawback of this approach is that the companies whose stock prices are rising become relatively larger while companies whose stock prices are falling become relatively smaller. If markets are less than perfectly efficient and stock prices are anything other than fairly valued, cap-weighted indices will tend to favor overvalued companies.

“Smart beta” strategies use different weighting schemes to construct a portfolio, involving metrics such as dividends or low volatility, or even equal-weighting, all of which sever the link between price and weight and tend to provide a value tilt to the portfolio. The reason for this is that, when rebalancing the portfolio, these strategies result in buying low and selling high. Portfolios based on market cap-weighted indices will often do the opposite when rebalancing, buying more shares of the companies whose stock prices are going up, and vice-versa. According to Research Affiliates, LLC, “smart beta” strategies must also encompass the best attributes of passive investing, such as transparency, rules-based methodology, low costs, liquidity, and diversification.

Does this mean that “smart beta” is a panacea that will bridge the gap between active and passive investing? Many of these strategies have back-tested well and have become increasingly popular, resulting in large inflows of capital. Rob Arnott, one of the pioneers of smart beta at Research Affiliates, has written about rising valuations in smart beta investments as a result of their soaring popularity (“How Can “Smart Beta” Go Horribly Wrong?”). He cautions against “being duped by historical returns” and advises investors to adjust their expectations for future returns to account for mean reversion. He and his co-authors think there is a possibility of a smart beta bubble in the works, due to the rising popularity of such strategies.

And what about traditional passive investments? Is there still room for these vehicles in an investor’s portfolio? Absolutely, particularly in the more efficient sectors of the broad market.  Even Arnott believes “there is nothing “dumb” about cap-weighted indexing.” At Parsec, we stay abreast of current investment trends, but use a measured approach to portfolio construction that is research-based and backed by sound financial theory. We don’t believe any one investment is particularly “smart” or “dumb,” but rather that there is room for different types of investments within the context of a well-diversified, well-constructed portfolio.

Sarah DerGarabedian, CFA
Director of Portfolio Management

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Brexit: What is it and what are the investment implications?

There have been many headlines recently about the so-called “Brexit”, or the possibility of the United Kingdom leaving the European Union. There is a referendum on the subject coming up on June 23 in the UK, with current polls showing 47% in favor of staying and 40% in favor of leaving. This is not to be confused with the “Grexit” fears from a few years ago about the possibility of Greece leaving the European Union as well as the Euro currency. The UK is different in that it is a member of the EU, but continues to use the Pound as its currency rather than the Euro. Therefore, the UK maintains its own central bank and monetary policy. The main effect of such an exit has to do with trade agreements within the EU.

Potential negatives of an exit include a possible slowdown in the UK economy, short-term local stock market volatility and\or depreciation in the Pound. The EU represents about 50% of UK exports but only about 10% of imports, so if trade agreements are less favorable as a result of the exit then the UK stands to lose.

There are also positive factors to consider with regard to the UK. According to Goldman Sachs, the economy (as measured by Gross Domestic Product) in the UK is projected to grow faster than that of the US or the other Euro area countries in both 2016 and 2017. The Pound has already fallen 9% against the dollar over the past year, and the UK stock market has underperformed both the S&P 500 and the MSCI EAFE index over the same period. A vote to remain in the EU would remove the current uncertainty, and could be a catalyst for UK stocks to reverse their recent underperformance. If the vote is to leave the EU, many trade agreements will need to be renegotiated. This process will likely take years to complete, while UK stock market volatility should be short-lived.

To quantify our clients’ potential exposure to the UK, in a typical portfolio our target weighting for international stocks is about 26% of the overall allocation to equities. Of this amount, approximately 1/3 is emerging markets and about 2/3 developed markets. The UK is considered a developed market, and makes up about 20% of the MSCI EAFE index, which is the primary benchmark for most actively managed developed international mutual funds. This would imply that roughly 3-4% of our typical stock portfolio has exposure to UK equities through mutual funds, plus any additional exposure through individual stocks we might buy that are headquartered in the UK.

Since the outcome of the Brexit vote is impossible to predict with certainty, portfolio exposure to UK stocks is low and the effect of the vote on stock prices is indeterminate, we are maintaining our current target weights in international stocks.

From a diversification standpoint, investing in international stocks reduces overall portfolio risk since foreign stocks do not move exactly in tandem with US stocks. Sometimes international investing improves portfolio returns and sometimes it does not. In recent years international stocks have underperformed relative to the US, but historically there have also been periods of significant outperformance. While there will be more hype and headlines as the June 23 vote approaches, we remain committed to long-term investing in a globally diversified portfolio.

William S. Hansen, CFA
President
Chief Investment Officer

Bill

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The Challenges of Initial Public Offerings

This is a blog post of ours from 2012 that we thought was worth re-posting.

 

There have been many headlines recently regarding initial public offerings (IPOs) of technology companies.  These headlines tend to generate media buzz and excitement from investors eager to make a quick profit or get in on the next big thing.

The first issue investors face is access to IPOs. In an IPO, the company sells shares to one or more investment banks.  These firms then market the shares to their clients at a slightly higher price known as the Public Offering Price or “POP.”  These clients are typically large institutions rather than retail investors looking to buy relatively small amounts.

You can look up the prospectus, or S-1 registration statement, for any IPO at www.sec.gov.  If you do this, you will notice that the price and number of shares are blank until the last minute. These are filled in right before the registration statement is declared effective by the SEC and the shares start trading.  You do not know the price while you are reviewing the information to make an investment decision.

When trading opens, the shares may sell for above or below the POP.  It all depends on the supply and demand for shares.  Recent technology IPOs have tended to significantly underperform the overall market.

Some recent companies have come public at valuations of over 100 times trailing earnings, while the market as a whole currently trades at about 17 times trailing earnings.  What does this mean from an investment standpoint?  Mathematically, these new companies must continue to grow at a much faster rate than the overall market for a long time in order to justify their current stock prices.  If there is an earnings disappointment, these high-projected growth companies will tend to fall in price more than a company trading at a more reasonable valuation.

You may love the product, but that may not make for a good investment.  Let’s take the airline industry as an example.  I love the idea that you can get on a plane and go almost anywhere in the world.  But the industry has been plagued with bankruptcies, with many examples of common stockholders being completely wiped out and losing their entire investment.

How about the auto industry?  I love the product, and everyone has one.  In the early 1900’s in the US, there were thousands of auto manufacturers.  Now there are three.  What are the chances that you as an investor would have picked one of those three?  And two of them went through bankruptcy in the past three years.

In addition, there are many quality companies currently trading at valuations below that of the overall market that have increased their dividends each year for 25, 35 or over 55 years.  While we invest in technology companies, we prefer to focus on established companies with solid balance sheets that have the potential for long-term growth of earnings, dividends or both.

 

Bill Hansen, CFA

Managing Partner

February 12, 2012

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