The whisky blenders of finance

I help organize events on behalf of my US university for alumni who now live in London. Talks by professors visiting the UK are always in demand, selling out in a few days. Theatre and opera events do quite well. Our annual whisky tasting, however,  is by far the most popular, selling out in a few hours.

I’ve learned a thing or two about whisky at these tastings. The vast majority of whisky is blended - the master distillers carefully select from different casks and vintages. They attempt to marry together different characteristics to achieve an optimal whisky.

Even the highly esteemed single malt whisky is, in reality, a blend of whiskies from a single distillery. The whiskies are selected for their ability to integrate together to create a refined product far superior in the sum of parts than any individual cask.

In investing we never miss a trick, so much like the master distillers, we have created “Smart Beta” indexes that attempt to take the best “factors” of various investment styles and blend them together to create a better index.

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The resulting product is supposed to have a lower “beta” or deviation from a major index (such as the S&P 500). This lower volatility is theoretically to ensure that our product is more resilient in a downturn but deliver superior returns in normal times.

I’m not sure about the “smart” part of the label but it takes an army of math and finance PhDs to create these products, so marketing departments possibly have picked up on that.

As an example of factors - it’s well researched that small-cap stocks give overall better returns over the long term. Momentum stocks - stocks that are moving higher, tend to keep moving higher. Low volatility stocks tend to give better returns. Value stocks - quality stocks that have been beaten down tend to go back up. As a master investor/ distiller, you can bring together the best factors of these investing strategies to create a smoother investment.

Ha. I just tricked you into understanding one of the most mathematically complex categories of investing.

More importantly, though, what does smart beta mean for you? Should you use this strategy and if so how much?

  • Although factor investing has been around for decades, it has only really taken off in the last decade as indexing and computing power has increased.

  • The mammoth institutional investors have also been buying these strategies in massive quantities in hopes of riding the next crash more smoothly.

  • This is basically a sophisticated type of index investing, so the costs are low. For those of you who know you should try out index investing, but find it too boring, this might be a more intellectually challenging alternative.

  • Will factor investing be more resilient in a downturn? The smart beta whisky hasn’t been sitting in the cask long enough to be properly tasted/ tested.

I guess the skill with the smart beta is the same as with whisky--- a fat slug (5% - 10% of your portfolio) is good to start with. The whole bottle is way too much.

Thanks,

Mallika

P.S. As a disclosure, I used to work for MSCI one of the finest purveyors of factor investing research until 2014. I have a number of readers on this blog who are smart beta experts, so I’m definitely going to be in trouble for leaving my circle of competence.