(Pictured: Peter Bull)

Consultants at Ibbotson Associates Australia have written a critique of smart beta products and suggest that investors need to add a “fifth dimension” to the usual characteristics to look for in such a strategy – capital preservation.

The asset consultants – Peter Bull, who is head of portfolio construction, and Michael Ng, who is an investment analyst – have had their critique published last week on the ‘Cuffelinks’ newsletter. They say “opportunism has combined with genuine exasperation to push the expanding range of beta products to the limits of common sense, to the realm of the scientific and beyond”.

In the selection of a smart beta strategy Ibbotson has traditionally recommended four main characteristics: rules-based, transparent, diversified, high capacity exposure; low cost; low turnover; and better expected risk-adjusted returns and total risk than market-cap indices.

But revisiting their assumptions, the consultants say these criteria represent just a “laundry list” of their own biases and preferences. They offer no compelling basis to choose one option over another other than it should perform better than market cap. Other criteria are inherited directly from market-cap indices themselves.

“So, our preferred fifth dimension of smart beta is about as common sense as it gets: capital preservation,” the consultants say. “This requires investors to leave behind the world of mathematical precision and get back to the reality that valuation matters. As simple as it sounds, the benefit of capital preservation is most pronounced in a dynamic multi-period framework, or in the world in which we actually live.

“For example, equities as an asset class have terrible timing. They do well when people least need them to and poorly when other calamities tend to arrive, such as job losses and home foreclosures. Reaching for simple equity factor risk premiums can only compound this timing problem, so why make equities worse than they already are?

“Cash is of course the ultimate exemplar of capital preservation. In a typical single period investment problem, it is the most boring asset in that it is the only one that offers a completely fixed nominal return. But its very fixed-ness in one period opens up more possibilities over multiple periods, as it offers the possibility to plan in a future that is otherwise unknown.”

They say that smart beta strategies which have no built-in control for valuation risk are susceptible to bouts of extreme overvaluation and risk the permanent impairment of investor capital. For example, what will be the warning signs when a low-volatility smart beta strategy becomes overpriced?

Here is a link to their full article: http://cuffelinks.com.au/the-fifth-dimension-of-smart-beta/