Smart Beta Investing Has Underlying Problems

Whether markets are up or down, investors are always looking for ways to beat the odds. Everyone wants to feel like their investing strategy is as solid as it possibly can be, regardless of the market conditions. One such strategy is a smart beta investing approach.

smart beta investing

What is Smart Beta Investing?

Roughly fifteen years ago, a professional services firm called Towers Watson coined the term “smart beta.” However, the term was around long before that, dating back to the 1970s. It took more than 30 years for the first beta ETF to launch in 2003. Since then, smart beta fund managers have been tweaking and refining their investment strategies and methodologies.

According to ETF.com, “with 1,209 ETFs traded on the U.S. markets, Smart Beta ETFs have total assets under management of $1,574.77B. The largest Smart Beta ETF is the Vanguard Value ETF VTV with $101.00B in assets.”

Smart beta refers to enhanced indexing strategies that seek to exploit certain performance factors in an attempt to outperform a benchmark index. Smart beta investing is essentially a combination of both active and passive investing. Taking the best of the two for the most optimal outcome.

Smart beta aims to give investors an edge by lowering risk, increasing diversification and decreasing overall cost. All this while creating the most optimal portfolio possible. Efficiency and value are the two main points of interest. At least one or more of these factors are rolled up into customized indexes or ETFs. However, as IU Einstein and Quantitative Expert Nicholas Vardy explains…often the instant a smart beta strategy is introduced through an ETF, it stops working.

The Underlying Problem

Just last month, Nicholas Vardy wrote an article for Liberty Through Wealth called “The Underlying Problem with Smart Beta ETFs“. In it he explains some of the less noted issues with the investing approach.

“These smart beta ETFs bet on factors like momentum or the Dividend Aristocrats to beat the market. Each of these strategies is backed by research conducted at the world’s leading investment firms and business schools. Yet I’ve been disappointed by the real-world performance of smart beta ETFs. It seems that the instant a strategy is introduced through an ETF, it stops working.”

Nicholas goes on to reference an essay from Stanford Medicine professor John Ioannidis, called ‘Why Most Published Research Findings Are False”. In it, Ioannidis reveals how the “results published in many medical research papers cannot be replicated by other researchers.” Ioannidis’ financial counterpart, Campbell Harvey, a professor of finance at Duke University, estimates that “at least half of the 400 “market-beating” strategies identified in top financial journals over the past years are worthless. He challenges academics to take any so-called winning strategy and ask a different set of researchers to replicate it. And chances are about 50-50 that they can’t. Even worse, Harvey argues that his fellow academics are in complete denial about the problem.

Data Manipulation

Vardy then goes on to talk about how smart beta data can be manipulated…

“In statistics, a p-value represents the probability that a finding is statistically significant – attributable to an actual factor and not pure chance. For example, it will show whether a particular drug works or whether value stocks outperform over time.

The problem is this: Researchers twist the data – blatantly or subconsciously. They may cherry-pick the metrics used or adjust the time period studied to obtain a statistically significant result. We can blame “the system” for this problem.

Young finance professors can publish a paper with an eye-catching find in a prestigious journal – and they just might get tenure. As a result, investment strategies that look terrific on paper often flop in the real world.”

Smart Beta Investing – Summarized

As Nicholas and others have pointed out, many of the strategies surrounding smart beta investing are quite impressive. However, now that the term smart beta has been around for more than a few decades, it has lost some of its magic. The real world performance of smart beta ETFs has often missed the mark.

To learn more about smart beta investing, value investing, insider trading and more…sign up for one of our free e-letters today. Just visit our best investment newsletters page and select a free mailing that fits your investing style. If you’d like to follow more of Nicholas Vardy’s work, sign up for Liberty Through Wealth today.

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Distressed Debt Investing

The bond market is roughly two times the size of the stock market. Stocks get most of the attention but big money is in bonds. And when it comes to distressed debt investing, there are some great value opportunities.

When investing in distressed debt, it takes some skill to separate the wheat from the chafe. It isn’t for the faint of heart. You have to sort through many companies – and sometimes countries – going through tough times.

But before I get too ahead of myself, let’s first take a look at what makes debt distressed. Then from there, we’ll dive into some strategies and different ways to invest.

distressed debt investing in bonds

What Is Distressed Debt Investing?

Debt is money loaned out to borrowers with the promise to repay. For example, a new company might borrow $100 million to scale its first product. Then depending on the loan details, the company will pay it back plus interest in the following years.

Although, if this company doesn’t scale as expected, it might not be able to pay back the loan. For example, it might have overlooked some regulatory issues. No matter the case, if sales and profits don’t follow, the company is less likely to be able to pay back the loan. And this is when the debt can become distressed.

Investing in Debt and Credit Ratings

The investors that initially lent $100 million consider it an asset. Although, as the probability of repayment decreases, that asset is worth less. And like any asset, you can trade it with other investors.

With large companies, you’ll often find that their debt trades on secondary markets. Because it’s an asset, one investor might be willing to buy it from another.

But as mentioned… when the underlying companies struggle, the value of the existing debt drops. Investors are unwilling to pay the full amount for a loan if there’s a higher chance the borrower won’t be able to pay it all back.

To determine the chance of a default – a company missing its loan payments –, you can look at credit ratings. There are three top rating agencies: Standard & Poor’s, Moody’s and Fitch. They each have different systems but the lower the rating, the more distressed the debt becomes.

Companies can even file for bankruptcy and still return money to investors. As a company goes through that process, it might be able to pay back some – if not all – of its loans to bondholders. If the company is reorganizing or liquidating, it might sell off some of its assets. This is why distressed debt investing continues to see trading activity.

Bonds are often considered safer because bondholders come before stockholders. They’re first in line to see money returned during tough times.

Distressed Debt Investing Opportunities

For distressed debt investing, you can find opportunities with large brokers. Schwab, Fidelity and others provide access to corporate debt. Although, it can be more challenging than investing in stocks.

Due to increased risks with investing in distressed debt, there tends to be less trading activity. This means fewer opportunities to buy the bonds from sellers. On top of that, when trading debt, there can be higher minimum requirements.

For this reason, you’ll often see more activity from large funds. They also tend to have a better understanding of the legal process when it comes to bankruptcy and distressed debt. But nonetheless, feel free to explore what your broker provides.

If you buy into some distressed debt and the company turns around, that can provide some big returns. You might pay pennies on the dollar for certain bonds. And it all comes down to finding better ways to measure both the potential risk and reward. Then comparing that to the current market price of the bonds.

Diversify With Bond ETFs

As always, it’s good to diversify when investing. To do this, you can invest in distressed debt across industries. And as alluded to before, you can also invest in distressed sovereign debt. Some countries around the world struggle to meet their debt payments as well. Although, analyzing a country’s financials can be more difficult.

To buy distressed debt, it can require a lot of due diligence. That’s why many investors decide to go with debt funds. Due to the complexity of distressed debt investing, this might be a better path to take.

One popular fund is iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG). It has a wide range of bonds and some are more distressed than others. Due to the higher risk on average, it pays investors a higher return.

There are many more funds to start when distressed debt investing. Although, it’s good to balance portfolios beyond bonds. If you’re looking for more investing opportunities, check out these free investment newsletters. They’re packed with insight from experts.

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