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Is Smart Beta a Game-Changer?

Posted by Anthony Villis, Managing Director

The passive vs active debate has divided the investment industry for decades with academics arguing for empirical evidence and high profile fund managers defending the value of expertise. There are strong opinions on either side of the fence but is this debate old school? Investors are moving away from traditional market capitalisation-based indices to alternative strategies, known as smart beta. The emergence of smart beta (also known as alternative beta) is a new style of investing developed to seek better returns and lower costs in an uncertain economic climate. Research Affiliates, the US-based pioneer in smart beta strategies, define it as:

“… a rules-based portfolio construction process. Traditional index-linked strategies rely on price to decide which stocks to invest in and how much of each to hold. But the stock market is not always efficient, so stock prices don’t always accurately reflect a company’s economic footprint. Smart beta strategies seek to exploit these market inefficiencies by anchoring on factors other than price. In other words, smart beta strategies break the link between price and portfolio weight in an effort to deliver better-than-market returns.”

In a climate where keeping costs down is seen as increasingly important, active management can be expensive. You’re paying for the time and expertise of an investment manager, as well as the transaction costs, which can quickly mount up. When only around 1% of actively managed funds consistently beat the market, there are no guarantees that investors will get the returns they’re expecting.

In markets where there is widely available and extensive knowledge and an abundance of ready information it’s hard to justify paying an active investment manager because everyone has the same level of insight. However, in hedge funds, small-cap, and emerging markets for instance, where knowledge is not as detailed or comprehensive there is more potential for active managers to add value.

We tend to use a combination of active and passive instruments in our portfolios. The active funds build a defensive portion designed to primarily protect against downside risks, using a group of strategies that derive their returns differently. Often active managers who beat the market actually do so while carrying large amounts of hidden risks. However, if the downside performance is managed effectively, a portfolio can be average on the upside while still providing good risk-adjusted performance. This approach is in line with our mandate, which is mainly wealth preservation. Our aim is to provide a steady, rather than erratic, investment journey.

The passive funds are then used to replicate development markets equities, in the US, UK and Europe for example.

In recent years, many investors have moved to low-cost passive investment funds. Bloomberg reported that in 2015 “a record [£293 billion] in net inflows to low-cost and passively managed index funds and exchange-traded funds (ETFs) at the same time that [£118 billion] has been withdrawn from active mutual funds.” In fact, back in 2013 the Financial Times reported that an Ignites poll of fund management professionals, many of whom make their living promoting active products, showed that two-thirds have invested a sizeable amount of their own savings into passive products.

Passively managed funds are designed for long-term investing and when markets take a downturn there is no place to hide. If there’s a sell-off and you’re in a passive instrument your drawdown will reflect the full market sell off. In a cyclical market of ups and downs it’s important to keep a close eye on how your passive fund is performing over its full lifespan.

The Arrival of Smart Beta

In the aftermath of the 2007-08 global financial crisis investors became more focused on controlling risks and costs than simply maximising their returns. It’s in this context that smart beta investing has gained in popularity. Commentators have talked about it existing at the intersection between active and passive investing, touting it as the best of both worlds. BlackRock have predicted that the smart beta market will grow from approximately [£226bn] to [£1.93tn] by 2025.

Smart beta is essentially a systematic process to deliver a particular investment strategy. When that strategy works then the product does well, when the strategy does not work the product does badly. The systematic process helps ensure the human biases are removed, whether for richer or for poorer. For example, a smart beta product could use an algorithm to identify the ten worst-performing stocks in a chosen index and eliminate them from the portfolio. If an active manager were to do something similar by identifying the worst ten stocks and buying a fund, the common belief is that the smart beta algorithm would be the cheaper option, however at the moment there’s not a huge difference.

Smart beta is a relatively new approach to investment and the products have typically been provided through Exchange Traded Funds (ETFs) structures (a form of passive instrument). One of the drawbacks of ETFs is that they have not been adequately tested in severe stress scenarios (a significant market sell off) and there is some concern that liquidity may be illusory. In addition, one can only be cautious of ETFs when a fifth of ETFs were forced to stop trading during the US market gyrations of August 24th. And perhaps even more cautious when some of the ETF industry is urging regulators to change the trading rules rather than address the weaknesses of the ETF structure.

Industry Reception

How has smart beta been received by the industry? I recently spoke at a CityWire Roundtable event and my fellow panellists offered an array of views.

Justin Onuekwusi, multi-asset fund manager, Legal & General Investment Management, said: “In five years’ time, I think we will be talking a lot more about alternative beta. Style has driven a lot of the returns for some active managers, whether it’s low volatility, value, or small-caps. Where we want to pick active fund managers, we’re starting to assess their styles a lot more and combine them with alternative beta products. We also go down the alternative beta route where we have a bias towards income-generating assets in portfolios. I think talking about alternative beta really is the next step for all of us as multi-asset investors.”

Alena Kosava, senior research analyst, Tilney Bestinvest, added: “There is a lot of choice coming through in targeted or alternative beta... That is helpful in certain markets where active managers might not necessarily be able to add a lot of value, such as in controlling duration for gilts and Treasuries. Large-cap US equities are another area where beta can be accessed cheaply, but there are also areas of the market where – for liquidity reasons, for example – it’s hard to launch a passive strategy.”

Hugh MacTruong, proposition manager, Legal & General Investment Management noted: “It’s worth remembering that smart beta factors present good value at times but they’re quite poor value at others. The factors tend to perform at different times, so it’s not always simply a case of holding one or all of them. It can pay off to blend them, as they are able to deliver better performance than market-cap indices over the long term.”

Conclusion

Some commentators have heralded smart beta as a game-changer, however, reports of the demise of active or passive management are probably exaggerated. Different investors have different demands depending on a range of factors including appetite for risk, return required and environmental and social issues. Time will tell how much of an impact smart beta will make on the investment landscape but it’s fair to say that interest is increasing. When each approach has its own pros and cons, future debate is less likely to be over which to choose of active, passive or smart beta, and ultimately more likely to be about the benefits of blending all three.

If you need any help with managing your investments or with any other aspect of your financial lifestyle planning, then please give us a call on 020 7467 2700 or email us at: hello@firstwealth.co.uk.

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This document is Marketing Material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested

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