For the past few years, the notion of smart beta has been a hot topic amongst institutional asset owners. Last year, Russell Investments conducted a study of institutional asset owners and found that 30% of respondents are currently evaluating smart beta or anticipate doing so, on top of the 32% that already have money invested in smart beta strategies. And despite all of the interest in smart beta, there seems to be no clear consensus as to what smart beta even is, so much so that Russell devoted the first question of its survey to identifying the most popular definition.
Proposed definitions include the systematic exposure to investment styles (i.e. factors such as value, momentum, low volatility, profitability, etc.), alternative index construction methodologies (e.g. minimum variance, fundamental weighting, maximum diversification, etc.), some combination of the two or something else entirely. Some have gone so far as to say smart beta is nothing more than smart marketing of old ideas.
Active management, lower cost
Despite all of the confusion, one thing that is clear: smart beta is a form of active management. Whether the chosen smart beta implementation tilts to a desired factor, eliminates undesirable securities or combines securities in a more optimal manner, along the way an active decision is being made to construct a portfolio differently than the cap-weighted index. The marketing appeal of smart beta lies in the fact that these decisions are typically made in a predetermined manner at fees that can be less than traditional forms of active management.
It is the opportunity to use active management at lower fees that should be of interest to asset owners. Industry data suggests that defined benefit pension plans, and likely other asset owners, dedicate the majority of their equity investments to active strategies. And yet, active management is constantly under fire because of the high probability that it will disappoint investors. In a study published in 2010, the authors concluded that only 0.6% of domestic US equity mutual funds (just 12 funds from a sample of 2,076) deliver statistically significant alpha.[1] In other words, after accounting for fees and known factors of return (i.e. market, size, value and momentum), there was little evidence of factor timing or security selection skill by active managers. Based on our propensity for using active management, it would appear that we lack faith in such empirical evidence.
However, there is another interpretation that can be made from the academic research. Rather than dismissing the use of active management outright, such studies illustrate the importance of factors in the decision to employ active management. If no alpha exists after accounting for these factors, then perhaps the focus of any decision to hire an active manager should focus on their ability to capture the excess return potential of size, value, momentum or some other desirable factor, as opposed to a unique source of alpha. And of course, what is the most cost-efficient way of doing this? In this context, investment managers branded as smart beta managers are just one of the many active management options available to asset owners.
Investment beliefs
If the previous logic makes sense, then there remain a lot of questions for asset owners to consider in the active management decision. Some of these questions may include:
- Is there evidence that the outperformance of a factor will persist?
- Is the factor pervasive across markets?
- If more than one factor is desirable, how should they be combined?
- What are the factor exposures of my current portfolio?
- What are the available implementation options?
- What degree of transparency makes sense for my governance model (i.e. should the portfolio construction be simple or can a more complicated solution be considered)?
The answers to these questions will undoubtedly be unique to your plan’s circumstances and investments beliefs.
Smart beta may be an effective moniker for marketing old forms of active management as something new. But rather than dismissing the concept outright due to its sudden popularity, it does serve as a reminder to asset owners about what is actually being bought with active management. More often than not, active management involves an investment process designed to capture known factors of return -hopefully by design.
An exploration of the factors that are important in active management is a worthwhile exercise for asset owners that depend on the performance of active managers. This self-study will undoubtedly influence or be influenced by a plan’s investment beliefs. If some worthwhile factors are not represented in the portfolio, then that should serve as marching orders to plans looking to diversify the active portion of their equity portfolios. If a so-called smart beta manager can deliver other factor exposures at a low cost, then smart beta may not be such a dumb idea after all. Want to read a full version of this paper? Click here.
Graeme Hay is the Senior Manager, Strategy & Research at the Teachers’ Retirement Allowances Fund
[1] Barras, Laurent, Olivier Scaillet, and Russ Wermers. “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas.” The Journal of Finance 65, no. 1 (2010): 179-216.