Factor investing, or smart beta, has grown dramatically, but produces inconsistent results, explains Anthony Hilton, Evening Standard

Smart beta is the phenomenon of our times. If the feature of the last ten years has been the dramatic flow of money from active management to passive, the drama of the last five years has been the growth within passive management of a huge range of smart beta strategies. These offer asset owners not only the low cost market matching predictability which comes from tracking an index, but the prospect of outperforming that index by building in a style tilt.

Smart beta is also known as factor investing and as such it is actually not that novel. There are many private investors who are factor investors without knowing it because they invest only in small caps; there are others who like high yielders; others again who pursue a value strategy often by buying good companies which are friendless after a setback. They are all following the basic principle of factor investing. Smart beta at its simplest takes factors such as these and tilts the chosen index to have more of the favoured factor than it otherwise would.

Factor strategy

In reality, it is more complicated and more costly than that simple explanation would imply, but that is because even the conceptually simple factor strategy can be operationally complex to put into practice, particularly when it also involves shorting the unwanted factors or requires frequent rebalancing.

The big question is: does it work? That is what Professor Elroy Dimson, Professor Paul Marsh and Dr Mike Staunton set out to establish in a paper published in March in the Credit Suisse Global Investment Returns Year Book. The three academics are better placed than most to do such testing because over the last 20 years they have created what is arguably the world’s most comprehensive database of stock market returns. They can look therefore not only at what smart beta might achieve over five years but also at what happens over a 50 year cycle, and not just in the UK but in all the world’s major markets.

Academics and others have isolated more than 300 factors which in theory could have an effect on share prices, but most are too complex to be used in smart beta strategies. For the purpose of this exercise, and to keep it to manageable proportions, the team decided to test only the five most commonly used factors in smart beta – low volatility, size, momentum, value and income.

Mixed message

Looking first at the medium term, they assessed how each of these factors had performed in the UK market each year since 2008 and into which quintile of performance it fell.

Over almost ten years there is no clear or consistent winner – the results for all are mixed. One factor is top quintile one year, only to be a dog the next. Low volatility had three years at the top and three years in the bottom quintile. Size had three years at the top but only one year at the bottom. Momentum also had three years at the top and one year at the bottom. Value had one year at the top and five years at the bottom. Income never made it to the top, but was never at the bottom either. It spent all ten years in the middle three quintile bands, with a bias towards the lower.

The long term delivers a similar mixed message. It is clear, for example, that value outperforms growth and small cap outperforms large cap over a 50 year time horizon in the majority of – though not all – markets. The problem is that there can be very long periods of between ten and 20 years where the reverse is true. And of course no one knows in advance when one of these periods might start or, if one is already in one, when it might end.

So the message for clients is that smart beta is certainly smart – but only for some of the time.


Anthony Hilton has won many industry awards including European Business Writer of the Year, Wincott Business Journalist of the Year and the London Press Club's Business Writer of the Year. He joined Fleet Street in 1968 as a trainee on The Guardian. He was City Editor of The Times from 1981 to 1983 and City Editor of the Evening Standard from 1984 to 1989. He was then Managing Director of the Evening Standard for six years, before returning to the City Office as Financial Editor and economics leader writer for the paper. He has worked in television and radio, has written books on understanding finance and the City, and is a frequent conference and after dinner speaker and moderator on City and media matters. His interest in pensions was stimulated by a 19 year spell as a trustee of the various schemes in the Daily Mail Group. He currently serves a a member of the investment committee of the Harmsworth pension schemes.