I’ve been musing a fair bit recently about how advisers – especially in the US – should be using smart beta and factor ETFs. My overall bottom line (in true contrarian fashion) is that smart beta and factor funds have been a bit maligned, largely because they are the subject of huge marketing campaigns and a seemingly never-ending stream of new issues, championing increasingly niche strategies. It’s easy in my book to poke holes in the outlier factors and even more outlier ETFs – let’s be honest there are plenty of very dumb smart beta ETFs. But the central idea is still hugely important – that quantitative screens through a stockmarket can reveal a selection of stocks that have more interesting characteristics.
Quant investors have long understood that you need to treat all screens and mining projects with extreme caution – and subject any results to rigorous market testing. Smart Beta reminds me a bit of the psychedelic movement. It started off as a bunch of rigorous pysch egg heads talking about how to use naturally occurring compounds to deal with severe mental trauma in carefully controlled medical environments. It worked and then people like Tim Leary broke it free, and everyone was at it, man, and before we knew it the whole thing had blown up. But many decades later, patient researchers have re-emerged to highlight the core principles, and why they work. I suspect much the same will happen with smart beta. We’ll have the crazies claiming it’ll cure your portfolio ills and then after the inevitable crash, we’ll rediscover the essential truths. Which are? That careful screening of a market in a systematic fashion, allowing for fundamental market evolution, can reveal systemic strategies that over time can produce a better return by taking on more risk.
Crucially I also think we’ll realize that rather like the psychedelic movement, what matters is the portfolio context and how you use the tools available. In drugs research, you need to work with a professional guide in the right context. In a portfolio context, you need advisers who understand how, when and why to use different strategies.
One of my new publications called BeyondBeta tries to provide a sensible, critical guide to smart beta and factor investing. If you haven’t read it, go HERE and request a copy of the latest issue. I think it is pretty damned interesting but then again I would say that. One of the best papers in the latest (second) report is from US quant shop QMA. They examine when and why investors might switch between passive and active, or more pertinently active and quant. This for me is a central insight. Passive and active can co-exist and will have their own vices and virtues at differing points in the cycle. It is almost never either or, more both but at varying times. The other key point is to understand which type of market regimes favor a purely passive approach, others a more active quant approach. Traditionally the idea has been to keep core as passive – long term, boring broad market access – and then use satellite portfolios for more active approaches. The QMA analysis suggests an alternative approach. Here’s their key passage:
“The analysis suggests that when volatility is low, the investor should make a significant allocation to the core portfolio that tilts strongly toward quantitative managers. The gulf between the quant and passive allocations during these low volatility regimes is somewhat surprising given the high correlations between passive and active quant strategies (data not shown), but quants’ ability to consistently grind out higher returns net of fees turns out to be a significant diﬀerence maker. By contrast, more active strategies appear to struggle to find enough big “wins” during a low-volatility regime to overcome their fee disadvantage. However, the opposite is the case in high-volatility markets, when the satellite fundamental managers are allocated a much greater share. Fundamental managers are nimbler at exploiting the volatility, better suited to avoid drawdowns and take advantage of rebounds.”
The Honeycomb / P2P trade
I’ve been banging on about what I think is the simplest trade in history for months now in the listed debt funds space. In simple terms Honeycomb strikes me as too expensive (short), while P2PGI is looking really cheap to me, especially as the two funds strategies converge (thus go long).
Nice to see the excellent Alan Brierley come around to my thinking in a note to clients yesterday. Here’s the summary – which I entirely agree with.
“Since launch in 2015, Honeycomb Investment Trust has performed well, delivering an attractive yield, with impressively consistent monthly returns. Meanwhile, Pollen Street was appointed investment manager of P2P Global Investments in 2017, following a period of poor returns. Since then, we have been impressed by the recovery in returns which has been achieved despite the not insignificant headwinds represented by legacy issues.
The relatively short histories of these two companies are now reflected by the current ratings. While Honeycomb trades on a 13% premium and has recently put in place a £400m placing programme, P2P Global languishes on a 15% discount with a supply/demand imbalance being addressed by almost daily share buybacks.
We believe this rating differential is transitionary and expect the gap to narrow over the next 12-18 months. We moved our P2P Global recommendation from SELL to HOLD last September (Legacy issues overshadowing green shoots) and given solid returns since, and material progress in further reducing legacy issues, we now upgrade to BUY. In terms of catalyst, we would look for a continuation of the improvement in returns and an increase in the quarterly dividend from 12pps to 15pps, which would equate to a prospective yield of 7.4%. A change in name would help; not only is the current name misleading as it doesn’t reflect what the company does following a 2017 change in investment policy, but it leaves sentiment vulnerable to any broader negative headlines regarding the P2P sector, which is not proving to be as disruptive as originally thought.
Turning to Honeycomb, while acknowledging the impressive returns since launch, the shares are more than fully valued at these levels and we initiate with a SELL recommendation. While the company has achieved critical mass in terms of size, we believe that there is work to be done in terms of introducing more shareholder friendly terms. Diversifying what is a highly concentrated register and improving marketability is a primary challenge. To this end, a merger with P2P Global Investments, has obvious merits and the rationale can only intensify as the legacy issues are addressed.”
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