The world of investment management has long been divided into two: passive and active management. Passive seeks to track faithfully a reference index and deliver performance net of fees as close as possible to that index. Active management seeks to outperform either an index or an absolute return benchmark such as the return on cash. This bilateral relationship has been turned on its head in recent years by the advent of smart beta.

Smart beta offers a third way: the transparency, reliability and low cost of passive management allied to the outperformance potential of active management.

In the case of equities, this is made possible by ignoring indices constituted by weighting companies in proportion to their market capitalisation. Share price has been the standard ‘brick’ in index construction for decades but the design is not without flaws. Such indices are prone to bubbles wherein stock prices seem to lose connection with rational valuations, often for periods of several years.

Smart beta looks to avoid such bubbles by a variety of methods, of which the common theme is breaking the link between share prices and index weighting. Smart betas are devised on companies’ actual wealth creation or measures of risk. These alternative measures are the first step in making these strategies contrarian. Where price-weighted indices follow share prices faithfully up and down, smart betas aims to avoid the irrational exuberance that drives such ups and downs. Using its alternative measures, smart beta instead looks to offer investors better long-term, risk-adjusted returns. The second step to achieving this goal is their constitution as indices rather than active strategies. The mechanistic nature of rebalancing an index one or twice a year ensures that smart beta adheres to its principles and does not get lured into evaluations based on prices.

What smart beta offers is a way to avoid much of the noise of markets that drowns out many of the signals of fair value, and which wrongfoots many active managers. Smart beta proponents do not claim to have found the perfect measures of fair value. Rather, the frequent rebalancing to some measure of company wealth other than the stock price is a better proxy for fair value than the majority of traditional strategies.

The value of these new indices is precisely their combining of the best of active and passive. For several decades the savings industry’s evolution has occurred on parallel lines. Index-tracking has been given a new spurt by the advent of ETFs. Active management has expanded into trading strategies, shorting and illiquid holdings (i.e. infrastructure and private equity). But a successful synthesis of both active and passive has been lacking. In our view, smart beta offers us the best of both worlds.

An enhanced alternative

Passive management, or tracking the index, could be in fact an active strategy. We could go far as to say that clients of index-tracking have outsourced their portfolio construction to the index vendor. This challenging statement needs further explanation. Cap-weighted indices are not bad, either as benchmarks or as the basis for passive management. Passive management has proved a very effective form of investment management. Numerous studies prove that only a minority of actively-managed mutual funds outperform their benchmark index over the long term. In the parlance of factors, we could say that few managers seem able to understand and be able to exploit factors, including beta, successfully across the years.

But efficiency here, both as a reference benchmark and by extension as an investment strategy, should not be confused with optimality. The reliability of cap-weighted indices does not mean that passive management is the best, or indeed most efficient, investment strategy. Harking back to the year 2000, we should remember that index-trackers were in part responsible for the blind buying of tech stocks. Just because passive is a better strategy than many active strategies does not mean it is beyond improvement.

The power of rebalancing

Rebalancing is more than a mere necessity in the whole process. In a paradoxical way, cutting winners, ie stocks that have appreciated, and reassigning money to losers, underperforming stocks, is itself a powerful source of return.

When rebalancing occurs at a low frequency, one is reducing positions in stocks that are statistically more likely to be overvalued and increasing positions in stocks that are statistically more likely to be undervalued.

Low frequency rebalancing works by ignoring the noise of the market and harvesting returns automatically. In the spirit of smart beta, this mechanistic harvesting does not pay attention to share prices. Believers in active management might here again protest that intuitively it does not make sense for ‘blind’ rebalancing to outperform considered analysis. Again, one has to question how much additional wealth for clients derives from rebalancing by active managers.

A Cass Business School research suggests that almost any combination of stocks, reshuffled annually every year, would outperform a US equity cap index. To prove this, the authors generated 10 million portfolios of 1,000 stocks weighted randomly using equity market data. They then resorted each of the 10 million portfolios, using the same random process of creation, for each of 44 calendar years to 2011. Almost all the portfolios beat the market-cap index. Even when adding extra trading costs, the percentage of simulated portfolios achieving superior performance is highly significant.

Sceptics might wonder whether smart beta indices are really necessary if the majority of random portfolios would also produce higher returns that market-cap indices. Further studies from the Cass Business School found that most smart beta strategies based on company accounts data outperformed the majority of randomly generated portfolios. Outperformance here is defined as a higher Sharpe Ratio, or excess return for every unit of risk. Attractive Sharpe Ratios suggest that smart beta attempting to capture economic wealth, are not relying on anomalies or mere random probability for their success. There is something meaningful for investors in these strategies.

Fees do matter

Fees have always played a major role in returns and are a major concern nowadays in investment management. A great appeal of smart betas in index form is that they are closer to traditional beta management than actively-managed funds when it comes to fees. A simple reason is that smart betas follow a formula which means that the process is largely automated, just as for traditional index-trackers. This also has the great appeal of reliability. Clients can understand by themselves what they are buying and how it works. And lower fees mean more of any wealth created goes into client portfolios.

Conclusion

If smart beta heralds a revolution in investment management, why has it taken so long to arrive? We suggest that the industry has for too long expected innovation in investment management to achieve what is best done by addressing the flaws in both active and passive management together. Some of the tenets of smart beta have been evident in previous trends for decades, e.g. style investing (investing by factors), active quantitative investing (factor decomposition) and hedge funds (measurement by Sharpe Ratio).

Nevertheless, smart beta strategies faces the same challenges as any new trend that seeks to ignore market-cap indices as its reference. The strength of smart beta products, unlike previous trends, is that they provide their own benchmark by virtue of being indices themselves. The danger remains that investors wish to compare them with cap indices too rigidly. In terms of raw performance, smart beta may well do worse than market-cap indices for long periods (we should be clear that there is considerable variety among smart beta indices in terms of composition and performance too). If one acknowledges the length of some periods of irrational exuberance in capital markets, this should come as no surprise.

The risk remains, however, that investors expect too much from these new indices: continuously lower risk for continuously higher returns. Such unrealistic, and unpromised, expectations could lead to short or even mid-term disappointment. Hopefully, at least investors will have a new language with which to understand stock markets, stockprice movements and their actions.

Nacho Font is CFA, director, senior equity product specialist, smart beta strategies, HSBC Global Asset Management

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