Top 400 Asset Managers: Is smart beta all that smart?
There is no Holy Grail in investing, and new ideas have their limitations, argues Amin Rajan
During the 2000-02 bear market, investors wised up to the fact that nearly 70% of active funds were outperformed by passive funds (after fees) during the raging bull market of the 1990s. Alpha was scarce, illusory and expensive. Many paid alpha fees for beta returns. Henceforth, so the argument went, beta had to be the main source of returns – and passive funds its most cost-effective vehicle.
However, it wasn’t long before investors also realised that passives had their own limitations. Tracking the traditional market indices like the FTSE 100 or S&P 500, such funds over-weight large expensive companies at the expense of smaller inexpensive ones.
Money flows into the large companies because of their sheer size, not their intrinsic worth.
The resulting momentum overinflates market values in the upswing. It also causes extra volatility in the downswing, as the subsequent corrections overshoot the intrinsic value.
Hence, since the middle of the last decade, alternative methods of weighting beta indices have emerged under various guises, such as. ‘smart’, ‘enhanced’, ‘advanced’ or ‘engineered’. The variant known as smart beta has gained traction with pension plans worldwide, according to the 2013 Principal Global Investors/CREATE-Research global survey due out in late June.
Typically, it covers what are termed fundamentally weighted indices, minimum variance indices and momentum indices. In each case, the index is overtly tilted towards certain factors that generate a risk premium. The typical factors include value, quality, momentum and volatility. Their weightings constitute a novel way of harvesting these premia. Being ‘smart’ involves choosing the right factors and making the right judgement calls when rebalancing.
Uses and limitations
Evidence from significant investor groups since the 2008 crisis shows that this approach marks an advance over the cap-weighted passives. Unsurprisingly, therefore, it has featured in two of the three options open to pension plans when tackling their funding deficits.
The first one is to dial up the risk. This means venturing further out on the risk frontier via higher-yielding assets, as done by the iconic Yale Foundation in the last two decades. But most plans remain wary of extra risk, especially since their earlier forays into alternatives were hit by the mass redemptions in 2008 when liquidity dried up.
The second option is to squeeze more juice out of existing assets. This is the investor’s equivalent of the Holy Grail – targeting additional alpha without taking on further beta risks. This is being done by adopting smart beta that can potentially deliver cheap alpha.
The final option is to squeeze costs: get existing returns at a reduced fee. Large plans are in-sourcing many of their active strategies and switching them into the smart beta bucket, which is now by far the largest one in some prominent pension plans on both sides of the Atlantic.
By supporting the last two options, smart beta is in the ascendancy and some pension consultants have been the early advocates. However, its adopters need to be mindful of certain inherent limitations.
First, they expose themselves to risks other than those they are targeting. The factors typically targeted include value, momentum and volatility. But that still leaves a raft of other risks lurking in the background.
Second, many value strategies typically target financially distressed companies. When their share prices drop, the tendency is to buy more to restore the original weight and hope that the price reverts to the mean. But in the turbulent environment since 2008, mean reversion has not been the norm. Indeed, it has not been the norm for a long time.
Some stocks don’t revert to the mean, they just revert to zero. Similarly, minimum volatility indices are overly influenced by past volatility and correlations. Momentum indices haven’t had a fair wind in the volatile environment of the past five years.
Third, like all nascent strategies, the performance of smart beta is based on back testing that goes back no more than 15 years. Without multiple economic cycles, it is hard to know how ‘smart’ smart beta is. Indeed, there is a school of thought that sees it as merely an extension of what has long been known as enhanced indexing.
Our research paints three future scenarios. The first envisages a few blow-ups from the headlong growth of smart beta – in line with every big investment idea in the past. As a result, the index industry will go back to basics and the cap-weighted indices will re-establish their ascendancy.
The second scenario envisages that smart beta will go from strength to strength, as institutional investors intensify their search for low-cost alpha without taking additional beta risks. This pursuit will intensify especially if active management struggles to deliver acceptable returns within a value-for-money fee structure.
The third scenario cautions against projecting the here-and-now into the future. The world of investment is cyclical and self-correcting. The new wall of money into smart beta carries its own concentration and momentum risks. For active managers, it is already creating a pool of underpriced assets excluded from the indices. Thus, smart beta will be just another way of investing alongside traditional active and passive funds in the ever-changing investment universe.
In any event, it is hard to imagine the active portfolio dwindling to nothing. Many investors remain sceptical that markets are efficient; active management does work because some market segments are far less efficient than others. Besides, thanks to the behavioural biases of investors, there is widespread acceptance that markets suffer from bouts of anomalies that cause significant deviations from the equilibrium price. These can be – and indeed are – exploited regularly by active managers via specialised knowledge, lower trading costs and financing structures that enable them to ride out the price distortions over a long period.
Time will tell whether a formulaic approach like smart beta is better placed to exploit such distortions than the one based on high conviction.
In their heyday, hedge funds were seen as a disruptive innovation. What mobile phones did to land-lines, what low-budget airlines did to flag carriers, hedge funds were meant to do to active management – disrupt their business models. Some observers now bestow that role on smart beta.
Investment history is full of newly proclaimed eras that rarely survive the market cycle they are born in. New strategies often come and go. Smart beta’s ‘mid-life crisis’ will come when traditional cap-weighted indices do well or when active management comes back into fashion or when equities regain their mojo. Till then, smart beta will continue to ride the wave.
Amin Rajan is CEO of CREATE-Research