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

The Year of The Fiduciary Rule

For about a year now, the industry has witnessed much conjecture and debate about the proposed Department of Labor’s Conflict of Interest rule, also known as the “Fiduciary Rule.”  The rule attempts to broadly categorize anyone offering investment advice to retirement plans or IRAs as a fiduciary.  It is in the final stages of review with the Office of Management and Budget and is expected to pass.

The mechanics of how this works are seemingly straightforward.  An advisor recommending a rollover of retirement assets into an IRA or similar account would be considered a fiduciary.  That matters because a fiduciary cannot make a recommendation that would cause his or her income to increase.  The rule indicates a five-prong test to determine if a person is advising retirement assets.  If any of the following apply, you are now considered a fiduciary:

  1. If you advise on the purchase or sale of securities or property in a retirement account;
  2. advise taking a distribution from a plan or IRA;
  3. manage securities or property including rollovers from a plan or IRA
  4. appraise or offer a fairness opinion of the value of securities or property if connected with a specific transaction by a plan or IRA; or
  5. recommend a person who is going to provide investment advice for a fee or other compensation.

Retirement plan sponsors should take note because if you read the rules correctly, it suggests anyone (including laymen) offering advice to a plan participant or an owner of an IRA would likely be considered a fiduciary and could be held personally liable for their recommendations or advice.

Registered Investment Advisors may not see a significant change in business practice.  We are already considered fiduciaries.  However, broker/dealers (B/D) may not have it as easy.  B/Ds are generally not considered fiduciaries to retirement plans or IRA assets, they are instead held to a less stringent “suitability” standard.  In the light of the proposed rule, one of the chief issues B/Ds face is how to handle variable income and commissions.  Changing their business model to accept level income would likely be an onerous undertaking.  There is an unattractive alternative.  Under the DOL’s Best Interest Contract (BIC) exemption, the broker/dealer may be exempt from the fiduciary rules if certain requirements are met.  These include:

  • obtaining a written contract prior to the offering of any advice,
  • supplying the prospect information and costs for every investment they could own,
  • providing performance information on each investment,
  • fully disclosing compensation arrangements and
  • maintainging this information for a period of six years.

In addition to this, the aforementioned information must be maintained a public website. Consider the amount of work and man-hours it would take to become compliant with the BIC exemption.  Because of this, it is expected that smaller B/D’s will exit the industry or merge with larger providers.

One of the controversial rules surrounds the “seller’s carve out” and its impact on small business retirement plans (plans with either less than $100 million in assets or 100 participants).  Under the rule as proposed, the advisor is not considered a fiduciary to the investments of these small business plans.  I question why every plan, irrespective of size, wouldn’t be required to have a fiduciary.  After all, under this specific rule, if the DOL is trying to protect consumers, why protect some of them and not all of them?

In closing, we at Parsec have been watching this unfold for months and are eager to see the final form of the rule.  Perhaps an unintended consequence is that many customers and retirement plans may have to reconsider their advisory relationship.  Regardless of the new rule, it is important to always put the best interest of your clients first.  Parsec will be prepared for whatever the DOL comes up with.

Neal

Neal Nolan, CFP®, AIF®
Senior Financial Advisor
Director of ERISA Services

Downturns, Recoveries and Portfolio Income

The most unpleasant part of investing in stocks is definitely the periodic pullbacks. Unfortunately, these are part of the price we pay for more money in the long run.

When the stock market is going up, everybody feels good about being a long-term investor. It is the downturns that test all of our nerves and our belief in long-term investing. As one pundit put it – we can then see who the long-term “owners” of stocks are as opposed to the shorter-term “renters.”

Currently the S & P 500 is around 1946, down about 8.6% from its peak in May of 2015. The low point of the current correction was on 2/11/16, when the S & P was down about 14% from its peak. As a refresher, a correction is defined as a -10% to -20% retracement from a previous peak, and a bear market refers to a decline of more than -20%. We are currently in the 35TH correction or bear market since 1945, and during this time these have occurred about every 2 years on average. Prior to the current correction we had gone almost 4 years without a 10% pullback, so our memories of this sort of negative volatility had begun to dim.

Considering market declines of between 10% and 20% since the end of World War II, the average percentage decline is -13.8%. The average time to recover back to the previous peak level was 3.6 months from the low point. The correction we are experiencing is currently about average in magnitude, and if it were to follow historical averages we would expect a recovery sometime in early summer. Nobody knows for sure whether things will get worse before they get better, but studying past market conditions gives us some context as to the range of potential outcomes.

What do we do in the meantime? If your asset allocation is 100% stocks, we recommend that you stay with it or, if you have the ability, take this opportunity to add to your portfolio with monthly deposits (such as to your 401k or Roth IRA), periodic bonuses or other savings. If your chosen asset allocation includes fixed income, then we periodically rebalance to your target mix and add money to stocks at temporarily depressed prices.

In our portfolios that contain individual stocks, our recipe is as follows: start by focusing on high quality companies with the potential for rising earnings and dividends. Combine 35-45 such companies into a well-diversified portfolio. Regardless of what happens in the stock market over the next year, your portfolio income should be higher each subsequent year. The management teams of high quality companies with long track records of dividend increases are very reluctant to cut their dividends. Even in a recessionary environment, more companies should increase their dividends than maintain or cut them. There are many well-known companies that have increased their dividends every year for 25, 35, 50 or even 60 consecutive years. You may already own some of these companies, especially if you are a Parsec client.

Total return is comprised of two components: income and price appreciation. Over long time periods, the income component of total return has represented just under half of the overall return of the stock market. However, the variability of the income return has been much lower than that of the appreciation component. By focusing on those companies that we believe are likely to have consistent dividend growth over time, particularly for those of our clients who are retired and spending from their portfolios, we are setting up a condition where there is less uncertainty about a significant component of their overall return. For our clients with large cap mutual funds instead of individual stocks, the same general premise applies.

The equity portion of our client portfolios also includes small-cap, mid-cap and international companies, which we invest in primarily through pooled vehicles such as mutual funds and exchange-traded funds (“ETFs”). The fixed income portion is also well diversified, with a focus on short-to intermediate term, high quality instruments along with some high yield and international bonds for diversification and yield improvement.

We encourage our clients to focus on this concept of rising portfolio income to meet their investment goals and provide peace of mind during the inevitable corrections and bear markets that we will all experience at some point.

William S. Hansen, CFA
President
Chief Investment Officer

Bill