In an era when investors’ need for return far outstrips the realistic expected returns of equity markets, some investors believe “smart beta”, cheap, rules-based strategies that aim to outperform the market, may offer a free lunch.
Cheaper than active management, but promising more than index funds, the approach sounds like a solution in a challenging environment.
Although the uptake by investors has been enthusiastic, not everyone is keen. Burton Malkiel, the veteran index investor and author of A Random Walk Down Wall Street, is sceptical. “Smart-beta portfolios are more a testament to smart marketing rather than smart investing,” he says, repeating his argument in a special 40th anniversary issue of the Journal of Portfolio Management. He asserts that any outperformance of these products is purely the result of taking on more risk, making it less obviously an improvement for risk-averse investors.
The precise definition of smart beta is a slippery one. Even Towers Watson, the consultancy that claims to have come up with the phrase, has changed what they mean by it in recent years. “The traditional view of smart beta is that it improves access to existing beta opportunities,” explains the Towers Watson microsite on the topic. “For example, it provides low-cost benchmarks that are not weighted by market capitalisation.”
Non-market-cap weighted indices have been popularised by outfits such as Research Affiliates. Its indices, weighted by company metrics such as sales, cash flow and dividends, are used to manage $177bn worldwide. Equally weighted indices are also popular, as are other varieties, such as low volatility or low correlation.
According to Towers Watson, smart beta can now also be used to describe investment strategies that offer investors customised exposure to different themes or risk factors, although the implementation of these concepts is still challenging.
Smart beta looks like passive management, as it is low-cost, rules-based investment, but it could also be seen as eating active managers’ lunch, as it offers to outperform at a price closer to that of index funds than active funds.
“One could argue that smart beta also evolved out of the focus on charges as the be-all and end-all of investment profiling,” says Sam Lees, head of research at FundExpert, part of Dennehy Weller, the financial adviser. “Investors could be dazzled by the smart-beta label and also the lower charges, as compared with a traditional active fund.
“Investors who focus on a process for profiling and choosing the best-performing funds are more likely to achieve superior returns than investors who are focused primarily on price.”
Amin Rajan, chief executive of Create Research, adds: “Mr Malkiel criticises smart-beta strategies because they have not ‘reliably and consistently beaten the markets’ (his words). Name one strategy that ever has? I can’t.”
Mr Rajan, who predicts European pension funds will increasingly put their money into smart-beta strategies in fixed income as well as equities, agrees that smart beta is no panacea, but adds this would be an unrealistic expectation. Since the 2008 crisis, however, it has done well for specific reasons, he believes.
Smart beta can exploit the price anomalies created by central bank actions that have separated stock prices from their fundamentals, he says. Investors are becoming concerned about the risks of cap-weighted indices, which by design are tilted strongly towards the larger companies, reinforcing any overvaluation that may exist.
Finally, says Mr Rajan: “Smart beta is perceived as a device 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 done by chasing specific factor premia that can potentially deliver cheap alpha.”
In the end, Mr Rajan’s position is not so far from Mr Malkiel’s. The latter says: “Whether smart-beta strategies will perform well in the future depends crucially on the market valuations existing at the time the strategy is implemented.”
Mr Rajan predicts: “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.”
He adds a word of caution about relying too heavily on new ideas in investment: “Remember portable alpha?” Only those in the industry for more than a decade are likely to have any clear memory of this concept, once thought to be the next big thing.
Evolution: Next-generation strategic beta
Although Amin Rajan, chief executive of Create Research, looks forward to resurgent equity markets eroding the attractiveness of smart beta, and predicts that investors will go back to traditional active management, other people have more ambitious ideas.
Ido Eisenberg, portfolio manager for the European research-driven process at JPMorgan Asset Management, expects smart beta to develop and evolve as the theory becomes more sophisticated.
Smart-beta products are mostly based on academic research that has identified a number of risk factors – specific portfolio exposures that have historically delivered excess returns over long periods of time.
Most smart-beta products exploit just one return factor, he says. “By contrast, the next generation of strategic beta strategies will be intent on solving more than just single factors.” These strategies, he says, “will seek global equity returns from across multiple distinct return factors while simultaneously reducing volatility with diversification”. This does indeed sound like the Holy Grail of investments.
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