(Bloomberg) -- In the brave new world of next generation, active investment management, smart beta is all the rage. Smart beta relies on five major strategies -- or "factors" -- to fine tune market returns:
Value – buying cheap companies
Size – buying small companies
Quality – buying highly profitable and stable companies
Momentum – buying the trend
Low Volatility – buying defensive companies
Investments built around each of those factors have historically beaten the market, as the following chart shows:
The problem is that these factors are also riskier than the market, and smart beta funds now want to rein in that risk by diversifying. They blend as many as three or four factors at a time, rather than betting on just one -- so when one factor is down on its luck, others will hopefully pick up the slack.
Does it work? Have a look:
Using Ken French's treasure trove of factor research, Gadfly simulated an equally-weighted portfolio of value, size, profitability, and momentum factors. We found that this multi-factor portfolio outperformed the S&P 500 from July 1963 to December 2015 (the longest period for which data is available for all four factors, and the returns include dividends). That same portfolio also had a better risk-reward tradeoff during the period, as measured by the Sharpe Ratio.
Yet our multi-factor portfolio was still more risky than the S&P 500 (as measured by standard deviation) -- but less risky than investing in value, size, or momentum alone.
So there appears to be merit to spreading your factor bets, which may explain the explosion of multi-factor ETFs this year. Each fund has its own cocktail of factors, but the specific mix is probably less important than the factor diversification itself.
There are two potential spoilers, however.
First, fees are generally too high. Smart beta is as systematic as traditional market cap weighting, and many investors rightly wonder why smart beta funds are more expensive than market cap-weighted index funds.
Some fund companies are already answering that call. Goldman Sachs charges just 0.09% annually for its multi-factor ETF. State Street and BlackRock charge 0.15% and 0.35%, respectively, for their multi-factor ETFs. There's room for even lower fees, but these are clearly good moves.
The second potential spoiler in the smart beta world is investor enthusiasm.
If investors stampede into multi-factor funds, that might limit the underlying factors' potential outperformance. Smart beta maven Rob Arnott has already voiced concern about the growing popularity of smart beta and its possible chilling effect on expected returns.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.