Electronic copy available at: http://ssrn.

com/abstract=2474856
Betting On Dumb Volatility With Smart Beta
Claude Erb
TR
July 30, 2014
Electronic copy available at: http://ssrn.com/abstract=2474856
Overview
It is possible that some investors make the dumb mistake of buying high and selling low
The footprints of the dumb mistake of buying high and selling low show up as dumb volatility
With enough dumb volatility some smart beta strategies that aim to buy low and sell high may boost returns by 2-4%
Dumb volatility might exploit the behavior gap, a measure of the consequences of buying high and selling low
Focusing on live returns, a six factor model suggests dumb volatility has not been driven by value or size plays
Dumb volatility smart beta strategies may have the same risk-adjusted-returns but not the same dumb volatility risk
Some equally weighted dumb volatility smart beta strategies might already be facing capacity constraints
Investors face a dumb volatility frontier offering more return from dumb volatility in exchange for more dumb volatility
2
Four Dumb Volatility Strategy Examples
Dumb volatility strategies that aim to buy low and sell high assume that prices revert to value
Each strategy asserts that its method of harvesting dumb mistakes is the best
Some strategies rebalance to equal weights and others rebalance to some proxy for value
Regardless of the rebalancing approach, each strategy seeks to monetize the dumb mistakes of others
3
FTSE RAFI Equal Weighted S&P 500 Equal Weighted Russell 1000 Shiller Barclays CAPE
Note: Research Affiliates has positioned itself as the smart beta thought leader. Of course a belief in mean reversion is not proof of mean reversion. A belief in mean reversion is an explicit bet.
Dumb Mistakes And Buying High And Selling Low
15.2% 15.1%
10.4%
9.4%
8.8%
5.7%
5.2%
4.6%
4.2%
17.2%
23.7%
15.2%
13.0%
14.7%
8.9%
11.0%
6.4%
6.8%
-2.0%
-8.6%
-4.8%
-3.7%
-5.9%
-3.2%
-5.7%
-1.8%
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OAKIX MFCFX FAIRX PHIYX PIMIX MWTIX ABRYX PTTRX PCRIX
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Investor Return Total Return Dumb Volatility Return
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Using Morningstar data, Bogle noted a 2% investor behavior gap, the result of buying high and selling low
West and Larson noted that dumb volatility smart beta strategies outperformed by about 2% per year
In the spirit of Says law, the supply of dumb mistakes may create demand for dumb volatility smart beta
Note: Investor and total returns from Morningstar as of June 30, 2014. One common way of stating Says law is that supply creates its own demand.
The Dumb Volatility Frontier
Annualized Rebalancing Return = 1.127 x Residual Risk - 0.009
R = 0.9243
-1.00%
0.00%
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5.00%
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Annualized Residual Risk
(December 2004 to April 2014)
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FTSE RAFI
Market Cap Weighted
S&P 500
Shiller
Barclays
CAPE
Equal Weighted
Russell 1000
Market Cap Weighted
Russell 1000
Equal Weighted
S&P 500
Even if some investors make dumb mistakes, there may be no obvious best strategy to harvest dumb mistakes
Dumb volatility strategy risk-adjusted-returns have been similar, not dumb volatility strategy returns
As a result, the greater the amount of strategy dumb volatility the greater the return from dumb volatility
Dumb volatility investors have one major choice: where to invest on the dumb volatility frontier
Note: the equally weighted S&P 500 and Research Affiliates Fundamental Indices are early smart beta products. Because there is no common start date for smart beta products, this exhibit takes the launch
year of a FTSE RAFI product as the common start year for the four smart beta indices in the exhibit. Since dumb volatility could be uncorrelated with a factor model this exhibit uses residual risk as a proxy.
Dumb Volatility Frontier
(Return/Risk Ratio)
The Dumb Volatility Frontier And Dumb Mistakes
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Dumb Volatility
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Dumb mistakes are either corrected over time or they are not, just as the market is efficient or it isnt
Treynor and Hsu argued that the greater the dumb volatility the greater the dumb volatility return
The dumb volatility frontier maps out the trade-off between dumb volatility and dumb volatility return
Either there is a dumb volatility frontier or there isnt
The dumb volatility frontier is a bit like Pascals wager, proof of how to act is only available after the fact
Note: Treynors example says that the return from capturing dumb volatility, mispricing, is roughly the variance of mispricing. Hsu sees a benefit approximately equal to twice the variance. Rejecting the idea of
an assets price mean reverting to an unknown value, Perold favored cap weighting. Perold is a director of Vanguard
Dumb Volatility Frontier
Lower Dumb Volatility
Lower Return
Higher Dumb Volatility
Higher Return
When I Hear Smart Beta, It Makes Me Sick
William Sharpe is not a fan of smart beta
One of his concerns is that smart beta is not macro-consistent: not everyone can invest in smart beta
Dumb volatility smart beta is a bet that others will make an abundant number of dumb mistakes
Dumb volatility smart beta is like running a casino; it is profitable as long as others are willing to lose
Not all investors can run successful casinos
7
Smart Beta Return And Risk Overview
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Annualized Standard Deviation
(December 2004 to June 2014)
Other "Factor" Portfolios Possible "Dumb Volatility" Smart Beta Plays "The Market"
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Shiller Barclays CAPE
EW Russell 1000
EW S&P 500
S&P Low Vol
MSCI Min Vol
S&P 500
Russell 1000
FTSE RAFI
DFA Value
Berkshire
Hathaway
S&P High Beta
FTSE EDHEC
AQR
Momentum
Is there a way to identify the return drivers of different strategies?
Ang noted that assets and portfolios are nutritious bundles of factors
Arnott pointed out that all smart beta strategies are largely similar because of factor exposures
Asness focuses on calling a bet a bet and some smart beta strategies are a 100% bet on value
Note: Bloomberg data. There is no single definition of smart beta. A characteristic of many smart beta strategies is a tendency to avoid market capitalization weighting. December 2004 is not the
official live date for each of the strategies. It is perhaps close to the live date for the FTSE RAFI. The main focus is on comparing perhaps recent returns rather than focusing on ancient backtests.
Seeing Is Believing: Live Returns And Backtests
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Years Since Backtest/Product Launch
Cumulative Excess Return Since Backtest Inception Cumulative Excess Return Since Product Launch
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Backtests are used to frame forward-looking expectations but they may differ from real experience
For example, the backtested and live returns of the S&P GSCI have been quite different
Once actual history is available for an investment strategy, what use is backtested history ?
One possibly conservative approach is to focus on actual, not hypothetical, history
Note: Bloomberg data
Determining Approximately When Live Strategy Results Begin
Some actual smart beta products, and some thought leadership, can be traced back to 2004/2005
This suggests using 2004 as a real product start date, even if backtested returns exist going back to 1964
In an influential paper, Ioannidis commented on Why Most Published Research Findings Are False
Harvey noted most published investment backtests, published research findings, are likely to be false
10
Note: Bloomberg data. There is an abundant literature that provides a rationale for smart beta based upon multi-decade backtests
Smart Beta And A Six Factor Model
After the fact, factor models provide a sense of what drove a strategys returns, on average
Factor models are often used to illustrate being there, perfect foresight policy portfolio, exposures
Fama and French used a factor model to argue that active management, on average, was unrewarding
Frazzini, Kabiller and Pedersen showed that factors explained much of Warren Buffetts value-added
Cochrane noted that the growing number of factors in the factor zoo poses Tower of Babel challenges
A six factor model explained most of the time series variability of monthly returns
11 Note: Data from Bloomberg, Ken French and Andrea Frazzini (AQR). Herbert Simon noted that a wealth of information creates a poverty of attention. While these factors are frequently used for research
and marketing purposes, it is worth asking if anyone will recall these factors thirty years from now. Also, in-sample factor regressions provide exposure estimates known only after the fact.
Regression Coefficients
Has Value Been Important?
Since 1926, the average arithmetic pay-off to value, the value premium, has been close to 5% per year
Research presented by Fama and French in 1993 and 1996 supported a belief in a value premium
Some argue the return to value is a reward for risk and others suggest a behavioral cause
Hsu noted that most smart beta indices contain meaningful exposure to the value premium
Compared to DFA or Berkshire Hathaway only one dumb volatility strategy had a large value exposure
If the past is prologue, significant value factor exposures should translate into significant returns
12
Note: Data from Bloomberg, Ken French and Andrea Frazzini (AQR).
Regression Coefficients
The Disappointing Value Pay-Off
Since 2004, the average arithmetic pay-off to value has been a little over 1%
Compared to DFA or Berkshire Hathaway only one dumb volatility strategy had a similar value return
This small pay-off to value means that a significant portfolio value tilt has not been very rewarding
Ibbotson and Kaplan pointed out that many investors care about making comparisons across funds
Looking across funds, returns driven by exposure to value have had little impact on fund excess returns
13
Regression Returns
Note: Data from Bloomberg, Ken French and Andrea Frazzini (AQR).
The Persistent Decline In The Large Value Premium
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Axis Title
Rolling Ten Year Fama French Large "Value" Return (Large HML) Trend
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The pay-off to large market capitalization value investing has declined over time
It is possible that value has been overgrazed, a financial version of the tragedy of the commons
McLean and Pontiff question whether academic research destroys the return to investment strategies
Asness, Frazzini, Israel and Moskowitz called large cap value, large HML, quite a dodgy proposition
If the value premium continues to decline, rational or behavioral origin debates will be unnecessary
Note: Ken French data. The Fama French HML factor is a popular value measure. It is an equally weighted measure of small and large value factors. The large HML has declined over time and
the small HML factor has increased over time. See the Appendix for an illustration of the divergent behavior of large HML and small HML.
Fama French
(1993 and 1996)
Has Size Been Important?
Since 1926 the arithmetic average annual size premium has been about 3%
Research presented by Fama and French in 1993 and 1996 supported a belief in a size premium
Some argue the return to size is a reward for risk and others suggest a behavioral cause
Equally weighted dumb volatility smart beta strategies exhibited a pronounced small capitalization bias
Other dumb volatility strategies had a large capitalization focus similar to the Russell 1000
Across smart beta strategies, there seems to be no clear preference for large or small size exposures
15
Note: Data from Bloomberg, Ken French and Andrea Frazzini (AQR).
Regression Coefficients
The Miniscule Size Pay-Off
Since 2004, the average annual arithmetic pay-off to size has been about 2%
Looking at individual dumb volatility strategies, size returns have been fairly small
This pay-off to size means that a dumb volatility portfolio size tilt has not been very rewarding
Looking across funds, fund size returns have had little impact on fund excess returns
Interestingly, the total impact of size, value, momentum, quality and leverage can be close to zero
16
Regression Returns
Note: Data from Bloomberg, Ken French and Andrea Frazzini (AQR).
The Shrinking Size Premium
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Rolling Ten Year Fama French "Size" Return (SMB) Trend
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Berk argued the size premium should exist because it is predicted by theory
Schwert observed in 2002 that the size premium was seemingly more apparent than real
The trend Fama French rational measure of the return to size has been close to zero for some time
Is there a rational market dead mans switch for size, or could the size premium turn negative?
Fama French
(1993 and 1996)
Note: Ken French data
Dumb Volatility Is Either Real Or It Is Modern Phlogiston
Ultimately, the catchall alpha drove return differences across funds, not returns to factor exposures
Berkshire Hathaway had a 4% alpha, in sync with the popular idea that Warren Buffett is a skillful investor
Some dumb volatility strategies also had Warren Buffett-like alphas close to 4%
If there is a pay-off to dumb volatility, a factor model will see the dumb volatility return as skill
What challenges might face dumb volatility smart beta strategies going forward?
18
Regression Returns
Note: Data from Bloomberg, Ken French and Andrea Frazzini (AQR). Since the model does not include a dumb volatility factor, the returns to dumb volatility, if they exist, would show up in the
intercept term, alpha. Alpha does not have to be a measure of skill, it can simply be the resting place for returns a model can not explain.
Historical Capacity And Dumb Volatility
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Size Exposure/Capacity
(December 2004 to April 2014)
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Berkshire
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Shiller
Barclays
CAPE
Equal
Weighted
Russell
1000
FTSE
RAFI
DFA
Large
Value
S&P 500
MSCI
Minimum
Volatility
Russell
1000
Low
Volatility
S&P 500
AQR
Momentum
High
Beta
S&P 500
Equal
Weighted
S&P 500
FTSE
EDHEC
Larger Average
Market Capitalization
Smaller Average
Market Capitalization
Arnott noted capacity differences between strategies can make a significant difference
Moroz and Kose suggest that the smaller the average market cap the higher the implementation costs
Amongst these dumb volatility plays sector allocation had the most capacity, equal weighting the least
Note: Data from Bloomberg, Ken French and Andrea Frazzini (AQR).
Large Investment Capacity Small Investment Capacity
A Possible Inefficiency Example Berkshire Hathaway
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Warren Buffett compared believing in market efficiency to believing that the world is flat
From 1996 to the present, Berkshire Hathaway outperformed the S&P 500 by 2.5% per year
Berkshire Hathaways annualized total return: 10.6% per year
S&P 500 annualized total return: 8.1% per year
Some may see Berkshire Hathaways historical stock performance as evidence of inefficiency
Note: Bloomberg data
Success And Size
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Berkshire Hathaways May 1996 stock market capitalization was about $37 billion
Currently, Berkshire Hathaways market capitalization is more than $300 billion
Over time Berkshires market capitalization, relative to the S&P 500, has grown from 0.9% to 1.7%
Note: Bloomberg data
Size May Kill Opportunity
One Year Return Difference (BRK S&P 500) = -23.812 x Berkshire/S&P 500 Market Cap Ratio + 0.3411
R = 0.186
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Berkshire Hathaway Market Capitalization/S&P 500 Market Capitalization
(May 1996 to June 2014)
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As a strategy gets bigger, its ability to outperform can conceivably rise, stay constant or fall
In the case of Berkshire Hathaway, as it became bigger its rate of outperformance fell, alarmingly
One possible explanation is that investors have overgrazed Berkshire Hathaways stock
Another possibility is that Berkshire has overgrazed its own circle of competence
Though it is possible that history is more or less bunk, it could be that size kills
Note: Bloomberg data
Equally Weighted Smart Beta Value-Added Declined As Investment Increased
RSP S&P 500 Annual Return Difference = -270.79 x Relative Size + 0.0672
R = 0.0835
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0.000% 0.005% 0.010% 0.015% 0.020% 0.025% 0.030% 0.035%
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RSP AUM/S&P 500 Market Capitalization
(December 2004 to June 2014)
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Dumb volatility strategies with limited investment capacity may be quickly overgrazed
The value-added of the equally weighted S&P 500 has declined as investment has increased
Equally weighted portfolios tend to have a small capitalization focus, relative to the market
Buffett has emphasized moats, and investment capacity may be an important moat
Note: Bloomberg data. Investment in the equally weighted S&P 500 is proxied by the Guggenheim equally weighted S&P 500 ETF( ticker symbol RSP). The idea that value-added may be fleeting
as the level of investment rises is a common concern for investors. Of course there is no clear cut way to identify a strategys investment capacity limit.
Conclusion
Dumb volatility smart beta is an example of a bet resting on a number of assumptions
Some investors make dumb mistakes
Dumb mistakes are ultimately corrected leading to dumb volatility
Dumb volatility gives rise to a dumb volatility return and a dumb volatility frontier
The uncertainty surrounding this bet and its assumptions is probably typical of all bets
Dumb volatility smart beta is not a free lunch but it is a bet that there will be a lunch
Dumb volatility smart beta strategies are not born equal, some exhibit more dumb volatility than others
Investors seeking to maximize dumb volatility return should move out on the dumb volatility frontier
24
Appendix
A Tale Of Three Value Premia
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HML Large HML Small HML
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Note: Data from Ken French
The Fama French value premium, HML, is a widely accepted measure of the return to value
HML is a 50/50 mix of a Small HML premium and a Large HML premium
Small HML has outperformed HML and HML has outperformed Large HML
The Curious Small Value Premium The Trend Was Your Friend
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Rolling Ten Year Fama French "Small HML" Return Trend
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The Fama French small value premium has compiled an attractive record of accomplishment
Surprisingly, the trend small value premium has increased for the last 80+ years
From an asset allocation context, why invest in anything other than small HML?
The small value premium could be a free lunch, data nuances, a gift horse or a puzzle
Fama French
(1993 and 1996)
Note: Ken French data
The Troublingly Declining Large Value Premium
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Rolling Ten Year Fama French "Large HML" Return Trend
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In contrast to the small value premium, the trend large value premium has persistently declined
Fama and French point out that small and micro caps represent 10% of total market capitalization
This suggests that the value premium has declined for 90% of the market and increased for 10%
In a macro-consistent sense, investors chasing the value premium receive the large value premium
Fama French
(1993 and 1996)
Note: Ken French data
Three Trend Value Premia
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HML Large HML Small HML
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HML is a blended portfolio of two macro-inconsistent exposures
A small HML exposure, that gets better with age, that few can invest in
A large HML exposure, with a current trend return of about 0%, that many can invest in
Fama French
(1993 and 1996)
Note: Ken French data
Linking Size To Average Market Capitalization
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Fama French Size (SMB) Coefficient
(December 2004 to April 2014)
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S&P 100
S&P 500
S&P Composite
S&P Mid Cap
S&P Small Cap
A portfolios size can me measured with the Fama French size measure, SMB
Alternatively, size may be viewed as the average market capitalization of a portfolios constituents
The relationship between size, SMB, and size, average market capitalization, is a bit non-linear
Note: Data from Bloomberg and Ken French
BOND ETF Asset Growth Seems To Have Inhibited Further Best Ideas Exploitation
Best Ideas Benefit (BOND-PTTRX Return) = -0.3128 x (BOND AUM/PTTRX AUM) + 0.0055
R = 0.2102
-0.60%
-0.40%
-0.20%
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0.80%
1.00%
0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% 1.6% 1.8% 2.0%
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BOND AUM/PTTRX AUM
(Monthly Observations, March 2012 to May 2014)
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Little data with which to observe how asset growth reduces the opportunity to exploit best ideas
However, what little data that does exist suggests best ideas pay-off may fall rapidly with asset growth
Empirically, BONDs value-added opportunity seems to have been played out
Small ETF asset base =
Some value-added
Larger ETF asset base =
No value-added
Data: Bloomberg