Best of both worlds?

Written by Sandra Haurant
September 2013

Sandra Haurant looks beyond the buzz of ‘smart beta’ to explore what it really means for investors

Every now and again, a new term makes it into the investment lexicon. Although as a concept it has been around for a while, ‘smart beta’ is one of these recent additions, and it’s an area in which the pension investment industry is gaining interest. Those in favour of smart beta claim it offers an opportunity to move away from traditional market capitalisation-led investment, a way of pursuing improved returns at lower costs, and bringing about greater stability in the midst of volatile markets. It means a real change in the approach to investing.

While the term is widely used, the best name for smart beta is still up for discussion – it also goes by the name of advanced beta, engineered beta or alternative beta. And the definition is similarly hard to pin down. The Financial Times Lexicon puts it this way: “[Smart beta] can be understood as an umbrella term for rules-based investment strategies that do not use the conventional market capitalisation weights that have been criticised for delivering sub-optimal returns by overweighting overvalued stocks and, conversely, underweighting undervalued ones.”

Smart beta aims to get better returns than traditional passive investment, but the way it works can mean lower costs. A smart beta manager will still follow an index, but this index will have been designed, defined and screened in line with a particular strategy, which might be linked to fundamentals, risk efficiency or weighting, for example. State Street Global Advisors, which refers to smart beta as advanced beta, says the strategy has “active-like capability with passive benefits”. It says advanced beta is “indexing re-engineered - unlocking the potential for additional returns embedded in risk premia that traditional cap-weighted indexes do not access, while maintaining the diversification, transparency and cost benefits of truly passive indexing”.

Since it is based on an index, transparency is straightforward and day-to-day management is on the whole less onerous than an actively managed fund. As such, costs are generally lower than on active funds. But, as Parametric Portfolio Associates director of research – alternative strategies Timothy Atwill says: “It merges some of the benefits of passive and active investment, although there are some intellectual property elements so they are not always all that cheap.”

While smart beta may provide some sort of middle ground between active and passive, which camp smart beta funds fall into does rather depend on how you look at it. “It’s a bit like those pictures where different people will see a different image,” says bfinance head of risk Toby Goodworth. “Whether smart beta is active or passive depends on where you are standing. If you come at it from a passive point of view, it appears to be active. If you come from an active point of view, it appears passive. Sometimes it doesn’t fit in to either and so falls between the gaps.”

“It offers outperformance potential in the very transparent context,” says Atwill. Indeed, in many ways, smart beta is the rejection of traditional market capitalisation-based investment. Investors need stability and transparency, returns delivered with lower costs attached. “People are looking at it because there is cost focus in lower returning environment, and it is being proved more efficient [than market cap],” says Goodworth. “There have been a number of studies that prove that cap weighting is inefficient against random portfolios.”

For example, Cass Business School in London published a study in April that revealed that equity indices constructed at random by ‘monkeys’ would have produced greater risk-adjusted returns than an equivalent market capitalisation-weighted index over the last 40 years.

Co-author professor Andrew Clare said when the report was published: “We programmed a computer to randomly pick and weigh each of the 1,000 stocks in the sample; we effectively simulated the stock-picking abilities of a monkey. The process was repeated 10 million times over each of the 43 years of the study.

“The results of this experiment showed that many of the monkey fund managers would have generated a superior performance than was produced by some of the alternative indexing techniques. However, perhaps most shockingly we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index.”

One argument against the traditional market cap approach is that it tends to lead to portfolios that are overweight in large caps, and in one of its simp-lest forms smart beta can address this with an equal weighting strategy, putting equal emphasis on smaller and larger cap stock. But it can also mean screening for risk efficiency or momentum, for example. So you might take a mainstream index, but screen it to only choose low volatility stocks, for example.

Some argue that costs can be kept lower by using automatic screening techniques, but M&G director, fixed income, John Atkin feels strongly that these methods leave investors open to problems. “We have disagreement with the idea that you can mechanically screen stocks. If you want to concentrate on high quality stocks, you can screen the universe for 120 companies that have everything you need. But that is flawed. In a high quality portfolio, spreads will be very low. You can’t always see problems coming. If you hit a default cluster, for example. You are not being compensated for the risk.” Indeed, Atkin says: “The best thing is to have a very diversified portfolio and screen it for value. We would bang the drum for a fully active solution; if you have a good active manager they will manage the downside.”

Smart beta, then, is about building and screening indices to provide more stability and better returns to investors. But for Atkin it is also crucial to ensure performance of these funds is measured properly. “One of the things that is dangerous about such beta is the implicit way that it removes the responsibility of benchmarks. In a way, it is saying that it is so clever it doesn’t need measuring. We would certainly encourage pension schemes to maintain measurable benchmarks,” he says. “What we are looking at is a better benchmark. I would encourage everyone to ask ‘is the benchmark doing what I want it to do?’”

Towers Watson global head of investment research Craig Baker describes smart beta as “not a substitute for good active management, but it allows resources to be focused on active managed in areas where one can’t systemise exposures”.

“There will always be a core of investors using it,” says Goodworth. “But if it were to become too popular it would become the new market cap, and that would effectively result in the same inefficiencies. It would become a victim of its own success.”

It has taken a while to make its mark, but conversations around beta efficient investing have increased, and so therefore, has the scrutiny of what it can achieve.

Written by Sandra Haurant, a freelance journalist

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