Smart beta – keep your investment resolution for more than a month

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

 

Like most of us, you probably started the year curing a post-New Year’s eve headache and taking time to think about your resolutions for 2016. While usually easy to make, keeping resolutions for the entire year is, as we all know, much harder. According to data compiled by the University of Scranton, only 8% of individuals are successful in keeping their New Year’s resolution.

So, in this article, I’ll give you some hints on how to keep your investment resolution for good.

My recipe: choose powerful investment criteria whose ability to generate performance is backed by strong academic research and implement your investment strategy in a disciplined and systematic way. The result will be top notch performance – as three of THEAM’s strategies demonstrated during 2015 in the amLeague NEWSManagers challenge. If you wish to know more about this asset management league take a look at Etienne Vincent’s article.

THEAM’s smart beta strategies lead the amLeague rankings in 2015

From a performance point of view, quantitative strategies outperformed their peers in 2015, according to data from amLeague and based on the sample available on the platform.

With two strategies ranked in first place (low-volatility strategies for investing in eurozone equities and in European socially responsible investment (SRI) stocks) and another finishing second (GURUTM strategy applied to European equities), THEAM’s strategies proved particularly efficient in 2015. And this success is not a ‘flash in the pan’ – the same two low-volatility portfolios that received awards in 2015 had already won the competition in 2014 – demonstrating the consistency of the strategy’s outperformance (see exhibit 1 below).

Exhibit 1: Rankings and performance of THEAM’s strategies

smartbeta sd en

Source: amLeague, as of 31/12/2015 and 31/12/2014. Past Performance is not a guide to future performance.

What explains such outstanding results?

When it comes to investing, the odds are that fund managers will stray from the initial investment strategy defined for the upcoming year. Deeply ingrained emotional patterns, personality traits or external factors from either their professional or personal environment can affect an investor’s decisions. Through the application of psychological theory, behavioural finance helps us understand why investors often make irrational choices. The same behavourial traits often part, or all, of the explanation for price movements in financial markets. Academic research has demonstrated that the irrationality of market participants leads to some mispricing which in turn creates opportunities that systematic quantitative strategies can exploit.

Let’s take some practical examples of behavioural biases.

Investors are usually overconfident in their ability to foresee the future. The dispersion in their opinions/analysis will be greater for those companies whose business strategies are perceived to be less convincing or provide less visibility. This uncertainty is reflected in higher volatility for these stocks’ valuations. Volatility tends to depress long-term performance because of the compounding effect of the ups and downs in the stock’s price on actual investment earnings. More volatile stocks have to perform much better than less erratic stocks to first restore the value lost in down periods and then to grow the sum invested (also known as the ‘principal’).

Another trait, known as the “lottery” effect, means many investors tend to be inclined to overpay for a small chance of winning big in more volatile stocks (due to the perception that it is probable they will generate higher returns) and underpay low volatile stocks. At the end of the day however, it is the ‘slow and steadies’ who win the race (remember the tale of the tortise and the hare).

Among others, these two biases, both deeply rooted in human psychology, explain the persistence of the low-volatility anomaly which defies the received wisdom according to which investors who take more risk will be paid higher returns over time.

As you will have understood, factors aim to generate alpha over the long run, by exploiting the irrationality of financial markets. However, not all factor strategies are equal. The construction of each factor is essential to extract the maximum level of alpha. We believe our proprietary strategies are well designed to pursue this goal as demonstrated by the amLeague’s 2015 rankings.

Smart beta was the top financial search term on Investopedia in 2015 and is undoubtedly going to make the headlines again in 2016. Looking forward, we anticipate that one of the next areas of innovation related to smart beta will focus on integrating environmental, social and governance criteria (ESG) and reducing the carbon intensity of investments, in response to demand from investors. In anticipation of this trend, we have recently launched on amLeague a Global Equity SRI Low Carbon strategy aimed at generating alpha through the combination of complementary factors while halving the portfolio’s carbon footprint.

 

Sebastien Denry

Investment Specialist, Quant Equity at THEAM

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