Top 400 Asset Managers: Active and passive come together
Far from being a threat to traditional active management, smart beta could represent a great opportunity for active managers, argues Noël Amenc
For many years, the active and passive investment worlds were clearly distinct. The goal of passive investment was to deliver the average performance of the market by replicating cap-weighted indices that were offered by a small number of providers. Active investment aimed to outperform those same indices, with, naturally, a much higher reward than that of passive investment in exchange for the outperformance. Two important phenomena have called this separation into question.
The first is the affirmation of choices and bets on beta in asset management, whether passive or active.
The stock market and financial crises of 2000 and 2008 have shown that what counted most in the performance of an investment was not the selection of stocks themselves, but rather that of the exposure to systematic factors (or betas) that were associated with them.
Whatever their intrinsic (or specific) qualities, all the stocks in the new information technology sectors or the growth or momentum styles suffered more from the crisis in 2000 than the stocks that were strongly exposed to the value style. In 2008, being in the financial sector was the key determining factor in explaining the sharp fall in the prices of publicly quoted stocks. More generally, the conclusion that asset owners drew from these crises is that whatever the stock-picking capabilities of their managers, the long-term performance, like the drawdown of the funds entrusted to them, resulted from their choice of betas.
This reaffirmation of the importance of betas, which was an academic truth that founded modern portfolio theory, and its recent developments that we call factor models, led the active investment industry to position itself in recent years in offerings that have focused strongly on betas and their replication.
As such, numerous diversified or private wealth funds build their performance no longer on stock picking but on affirmed bets on betas. This development of diversified or private wealth management is moreover one of the reasons for the success of exchange-traded funds (ETFs) in Europe. The main clients of the ETF providers are asset allocators who wish to be able to modify (rapidly, cheaply and in good liquidity conditions) the exposure of their funds or mandates to geographical or sector betas. The European ETF market is not ultimately driven by institutional investment management, which relies more on dedicated mandates or funds, but by the development of extremely active investment that is based on betas.
The second phenomenon, still in the field of active investment with the notable development of style investing, is that asset managers and their institutional clients have become aware of the importance of integrating the risks of the strategic allocation and the necessity to be exposed to the right risk factors, which are not necessarily those of the market. Here, too, the added value of benchmark construction is not a question of stock picking but a choice of betas. Ultimately, the risk allocation approaches popularised recently by the concept of risk parity show the importance of taking the true risks – and therefore the true betas – into account to construct a benchmark for an asset class, or even as part of the global asset allocation. The goal of genuine risk allocation is to use the variety of betas available on the markets to construct true asset diversification, no longer based on the appearance of the categories of assets or the market indices that represent them, but on passive investment.
It is clear that this affirmation of the importance of managing betas and their diversity will resonate in the passive investment industry.
It is legitimate to think that if betas are the main ingredients of active investment, then passive investment, whose very existence is justified by low-cost replication of betas, will wish to highlight its ability to deliver betas in their diversity.
Beta diversification and innovation
This search for the diversity of betas is the starting point for the convergence between active and passive investment. Today, index providers, passive managers and asset owners who have adopted a passive approach for their core allocation work on this diversification of their betas in two main directions.
The first of these corresponds to the implementation of support for the replication of pure or factor betas. This involves extending the search for granularity in the area of risks that was offered imperfectly with cap-weighted geographical, style or sector indices; these building blocks are tools for constructing the strategic allocation in different asset categories. In the area of equities, we can often find indices or building blocks replicating microeconomic factors such as size, momentum, the value style, the growth style, and also volatility or liquidity. We can find macroeconomic factors in the equity factor offerings, and also in fixed income, notably with solutions maximising the index’s exposure to a particular macroeconomic factor, whether it involves exposure to the growth or consumption of a particular geographical region, and also to credit, interest rate or inflation risks for the same regions.
Of course, if we speak about risk factors then we also speak about reward for that risk. Maximising the exposure to a particular risk factor poses the question of the fair compensation for the risk taken and therefore of the extraction of the risk premium that is associated with it. This is the area on which quantitative or fundamental research in finance has concentrated in the last 30 years. It has quickly become clear that the analogy between the return procured by cap-weighted or debt-weighted indices and the ‘normal’ reward for the risks taken on the stock or bond markets was questionable. More specifically, while cap-weighted indices are without any possible doubt the representation of market movements or of the weighted average performance of the stocks that make up the market, academic research, like the empirical work, has strongly questioned whether these indices were good benchmarks – in other words, benchmarks that are well-diversified and efficient in the sense that they represent the best return for the quantity of risk taken(1).
This concern to extract the right risk premia has given rise to the promotion of the smart beta concept in the last 10 years by the passive investment industry, which constitutes in a way the second ingredient of innovation in betas.
This search for indices, like the search for new risk factors, is a major element in the convergence between active and passive managers. Smart beta indices are a new marketing term for an old story, benchmark construction, which is at the heart of applied research in many asset management firms. The success of portfolio construction or optimisation tools, and securities selection and portfolio construction methods in active investment referred to as ‘top-down’ or ‘disciplined’ are ultimately the crystallisation of considerations that have been undertaken by asset managers for many years on sound management of the risks of their benchmark. Today, the quantitative methods that have led to the success of smart beta in Europe, like global minimum variance or value-type efficient benchmarks, were originally implemented in an active investment framework more than 15 years ago. In the same way, a large number of systematic factor replication strategies were for many years the beta ingredient of strategies that were falsely qualified as alpha and marketed as such by investment banks.
Commoditisation of research
Smart beta indexation is in fact a commoditisation of portfolio management research. This commoditisation is a revolution in the mode of passive investment and also gives rise to many questions and concerns in active investment.
In passive investment, smart beta indexation, which is of course sold on the basis of better risk-adjusted performance, questions passive asset managers’ initial and fundamental positioning. Up until now, passive managers were subject to very low performance, and therefore reputation, risk. Their job was to deliver the performance of a consensual reference, which was the average performance of the market. Whatever the value of this performance was, there was no way that the passive managers, or even the CIO of the asset owners who had chosen the index that represented it, would suffer from reputation risk.
With the smart beta index offerings sold on the basis of outperformance compared to cap-weighted indices, the reputation risk of index providers and passive managers increases, and all the more so in that the latter, who are sometimes concerned with having an offering with exclusive value-added, are led to do without index providers and to offer self-indexation on the basis of their own research in the area of smart beta benchmarks.
The outperformance compared to cap-weighted indices is based on different factor exposures and portfolio construction models that are certainly more efficient but that contain specific risks(2). The realisation of these risks, and especially the variability over time of the reward for the risk factors to which the smart beta indices are exposed, leave these indices open to periods of serious underperformance compared to cap-weighted indices. These periods can be longer than three years with maximum relative drawdown values greater than 10%.
This relative underperformance would not be very important if the smart beta indices replaced the market reference that is constituted by the cap-weighted indices, but this is not really the case. With the exception of a small minority of investors(3), smart beta indices are seen not as a substitute for cap-weighted indices but either as a complement (blended approach) or a substitute for active managers.
Given the motivation for investing in smart beta indices, the question of controlling the underperformance is posed and it is beginning to be handled by index providers or passive managers, who now offer control of the relative smart beta index risks compared to cap-weighted indices. Naturally this question of relative risk must lead to the comparisons between smart indices and active managers to be reconsidered; it is very unfair, for example, to compare the outperformance of a smart beta index that might be exposed to extreme tracking error of more than 10% and which is not subject to any ex-ante relative risk control with respect to the cap-weighted index, with benchmarked active asset managers who have very strict risk constraints.
It is moreover the subject of risk management rather than performance that could constitute an interesting response from asset managers in the future with respect to the commoditisation of the efficient benchmark construction process represented by the development of smart indices.
The attitude of active managers
Today, the attitude of active managers with respect to the smart beta phenomenon does not seem to be optimal in terms of technical and business positioning.
Two attitudes could be corrected in our view. The first consists of thinking that smart beta indices are more difficult to beat because they are better benchmarks than cap-weighted indices. This is not true. Roll (1992) has shown formally that, whatever benchmark he uses, a benchmark constrained active manager with a given view on expected returns and risk parameters, will end up with the same active weights and the same outperformance with respect to his benchmark(4).
Our research has shown that it is possible to use a smart beta benchmark as a starting point for an active stock-picking strategy(5). The results show that for the same capacity to select outperforming stocks, active managers who adopt a smart beta benchmark transfer their stock-picking value on top of this new benchmark. They ultimately benefit from the double added value of the stock picking and the smart weighting scheme that allows them to continue to outperform smart beta index investing. We also observe that asset management firms that have decided not to enter the competition on pure passive investment, but which have fundamental and quantitative research capabilities, can successfully develop so-called ‘active’ smart beta strategies that outperform smart beta indices. These indices should moreover be considered as references for measuring the performance and risks of these new active smart beta strategies.
The second attitude that managers sometimes adopt is what we see as the rather vain fight against beta. In this scenario, active investment is all about alpha – it would be enough to give up the benchmark as a risk management discipline in order to be able to prove that beta only exists because the benchmarks exist. Unfortunately, here too, this type of position is not particularly compatible with the results of academic research, which show that whatever the type of investment – including that which is the least benchmarked, like that of hedge funds– betas are a component of their performance. The best alpha is actually created by using the right benchmarks, ie, betas that are well decorrelated or that reflect tactical micro or macroeconomic bets.
Far from being a threat, the convergence between active investment and passive investment could be a fantastic opportunity for active investment. Today, there are more smart beta indices than stocks. These are great ingredients either for added value from diversified managers who will favour selection and diversification of these smart beta building blocks, or for managers who will be able to analyse the sensitivity of the smart beta building blocks to market conditions and, using their timing capacity in those conditions, to construct tactical allocation strategies between the building blocks. In both cases the added value to be created is enormous and justifies higher management fees than for simple replication of an index. The value proposition of active allocation between smart betas is all the greater in that unlike stocks, smart beta indices or building blocks are exposed in a very stable way to risk factors that are highly decorrelated and to specific risks that are measurable and fairly easy to diversify. These two qualities constitute the Holy Grail for all asset allocators and more globally for all managers.
Noël Amenc is professor of finance at EDHEC Business School, director of the EDHEC-Risk Institute and CEO of ERI Scientific Beta
1 For more details on this subject, please consult the review of academic literature conducted by Felix Goltz and Véronique Le Sourd in ‘Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?’ (EDHEC-Risk Institute Publication, January 2010), and Lionel Martellini’s editorial on the www.edhec-risk.com website ‘Inefficient Benchmarks in Efficient Markets’ (October 4, 2012).
2 On the subject of the risks of smart beta indices, it would be useful to refer to the ERI Scientific Beta Publication ‘Smart Beta 2.0’ co-authored by Noël Amenc, Felix Goltz and Lionel Martellini (April 2013).
3 Amenc, N., F. Goltz and L. Tang. October 2011. EDHEC-Risk European Index Survey 2011. EDHEC-Risk Institute Publication, and Amenc, N., F. Goltz, L. Tang and V. Vaidyanathan. April 2012. EDHEC-Risk North American Index Survey 2011.
4 Roll, R., (‘A Mean/Variance Analysis of Tracking Error’, Journal of Portfolio Management, 13-22, Summer 1992) considers the case where the manager aims at a target level of relative returns over the benchmark with the lowest possible tracking error with respect to the same benchmark and shows that the weight differences with respect to the benchmark (active weights) are the same whatever the benchmark used.
5 Please refer to the Smart Beta Investing seminar documentation, April 2013, available on request from Séverine Anjubault, email@example.com