Smart beta: A genuine revolution
Remember 130/30 funds? Most investment journalists do, because they delivered one of those periodic lessons in a major peril of their profession – getting caught up with next hot product. But there is arguably a bigger peril: affecting world-weary cynicism in place of critical engagement with new investment packages.
The 130/30 trend took the reasonable concept of portable alpha and, in dumbing it down, lost the key advantage of being able to pair beta with alpha from whichever markets happened to be the most alpha-rich. As with 130/30, the ideas behind smart beta are far from new – they can be found in academic papers dating back decades. But smart beta isn’t dumb- ing them down, but rather using advances in market data, computing power and trading to implement them in the real world. Indeed, there is a meaningful overlap between academia and the practitioners.
Traditional active managers often make this ‘old wine in new bottles’ criticism when smart beta comes up. A recent example is a paper from James Montier of value investor GMO that insists the outperformance comes entirely from (surprise) exposure to value and small-caps. Even
if this were true, it only goes to illustrate the point of smart beta – it delivers what active managers have been churning out for decades, but more cheaply and transparently and without the overblown claims for the arcana of qualitative stockpicking.
And, the benefits don’t stop there.
Right now, there’s a lot of talk about the ‘second machine age’. Robots are making inroads into more sophisticated manufacturing and intel- ligent machines will soon begin to chip away at the workloads of those in the less creative white-collar jobs – secretaries, desk researchers, some lawyers, news journalists, fund managers.
As a result we are reflecting more deeply on the nature of work, knowledge and skill. On this morning’s TV news a story about draconian new jail terms for UK trial jurors who look up defendants online led to the suggestion that they be replaced by robots programmed to consider only the facts of the case, for example.
Similarly, since smart beta came to prominence my sense is that pension funds’ portfolio management thinking has become more critical. They are now much more likely to interrogate their active managers’ benchmarks, for example. They seem to be more focused on investment beliefs – Do I get paid a premium for holding cheap stocks? Is the market efficient or inefficient? – because they understand how those beliefs should inform the strategy they pursue and the products they buy. And this has thrown light on governance decisions, such as where in a pension scheme’s structure choices get made and monitoring takes place. The contents of our supplement reflect these developments.
These were always live questions, and yet plenty of investors who think markets are inefficient have rightly employed active managers and then shackled them to market benchmarks; or spent far too much time choosing between one active manager and another at the expense of get- ting risk allocations right. It is as if systematising the investment process has helped to clarify things for investors, and empower them.
No wonder smart beta gives many in asset management the creeps. To be clear, I don’t think systems will replace fund managers tomorrow, anymore than I think they will replace trial juries. But engaging with the portfolio robots is a good thing that goes way beyond cost-cutting and right to the heart of all of our decision-making processes and structures.