The term ‘smart beta’ is still struggling for complete acceptance. Our panel of smart beta users and providers discuss what it is and how the market in these products is developing beyond equities.
Tom Caddick (head of global multi-asset solutions, Santander Asset Management)
Olivier Cassin (director and head of UK and Ireland institutional market, Lyxor)
Neil Morgan (senior pension trustee, corporate solutions, Capita Asset Services)
Philip Tindall (investment consultant and head of smart beta, Towers Watson)
Laurent Trottier (global head of index and smart beta management, Amundi)
Martin Weithofer (head of strategic beta, Deutsche Asset & Wealth Management)
Funds Europe: Smart beta has become an industry buzzword, but what does it really mean and how should it be interpreted?
Neil Morgan, Capita: For equities, smart beta is where you have a portfolio or index that has an implicit or explicit exposure to well-known investing styles or factors, such as value, that provide an extra return in addition to the general equity market return.
The weights in the portfolio or index won’t be market-cap, so this breaks the link between price and weight, and as a consequence of breaking that link, there will need to be regular rebalancing.
Crucially, the portfolio or index construction methodology is rules-based and is transparent, so that enables the returns to these styles or factors to be obtained relatively cheaply – more cheaply than equity managers, but perhaps slightly more expensive than traditional market-cap index funds.
Tom Caddick, Santander: I’ll add that smart beta is passive, in one form or another. If it is not traditional market-cap weighted, then it’s smart beta. Smart beta is a catch-all phrase for a market with considerable breadth and so it’s going to be very difficult just to talk about one thing when talking about smart beta.
Martin Weithofer, DeAWM: We call it strategic beta. ‘Smart’ would imply strategies are superior than others, which is not the case.
Also, there are strategic reasons why people look at this kind of strategic beta investment. They might want long-term exposure to equity factors, or exposure to quality sovereign portfolios.
Strategic beta itself is not something new. Using alternative weighting schemes and methods rather than a typical market-cap weighted index is not new. What is new is scepticism of investors that asset managers can deliver alpha, on the one hand, and the increasing interest in low-cost passive projects.
Laurent Trottier, Amundi: It would be wrong to talk about this as a buzzword because there is real money and real interest flying into the strategies. An Edhec survey showed about 25% of people surveyed already invested in smart beta and about 40% said that they will. The activities of some French pension funds and the Government Pension Investment Fund in Japan with its equity smart beta investment last year show that it is more important than a buzzword.
Caddick: I agree. By calling something a buzzword, is not to suggest that the underlying is a fad. But the smart beta mantle is probably ultimately unhelpful.
Trottier: Smart beta lacks a clear-cut definition and this leaves room for other investment approaches, such as quant, to be repackaged as smart beta, even if it’s a factor-based approach that is 15 years old! This is one of the dangers of smart beta becoming a buzzword.
And, finally, I’m not sharing the fact that smart beta should be associated with passive only. I think that we can have both passive and active smart beta. For example, an active smart beta portfolio manager has discretion to perform a stock selection before the optimisation, where he can decide whenever he wants to optimise this portfolio.
Morgan: Smart beta has to be transparent and rules-based, and no discretionary management is involved. What you’ve just described is active quant, and there is a lot of active quant around whose providers are now marketing themselves as smart beta. This is part of the problem.
Trottier: But if smart beta is about alternative weighting schemes then, for example, the minimum variance product – either a passive one with strict and transparent rules, or a discretionary one with discretion about the rules – could meet the smart beta definition.
Philip Tindall, Towers Watson: Smart beta is a buzzword, for better or for worse. I agree with Neil that it has to be transparent and rules-based, but we might go slightly broader in our definition. Smart beta is about constructing portfolios that are not market-cap based and that approach could be in any asset class.
Smart beta has passive-like, or beta-like, characteristics, which is what makes it simple, transparent and mechanical. There are inevitably some shades of grey in the detailed implementation of it, but it’s got to be about improving portfolio outcomes; you’ve got to improve risk-adjusted returns.
Our original definition of smart beta was meant in the sense of investors thinking smartly and moving from the market cap, so the definition is pretty broad in that sense. As was just said, it’s not new and many of the ideas in smart beta have been around for decades – for example, with equity style factors. Investors mostly used these for portfolio monitoring and pigeonholing active managers into certain categories. The innovation now is that investors positively want exposure to these factors, and low-cost implementable strategies have been developed to allow direct investment.
Olivier Cassin, Lyxor: Whenever there is a discussion around smart beta, the first question is always whether it’s a buzzword or not. I believe that we’re in the next phase now and the question is about whether smart beta serves its purpose for the many investors that have implemented it.
Caddick: The smart beta offering is diverse but often talked about as if it’s quite narrow. It’s like talking about hedge funds as one, or active management as one.
Morgan: What is relatively new about smart beta is being able to get exposure to those factors cheaply and transparently in a systematic way.
Weithofer: There are strategic beta strategies with more than ten years’ record, and what’s happening now is that ways of seeking outperformance or risk reduction in a cost-efficient way are crystallising.
Funds Europe: Is smart beta not just another form of marketing time, because it requires investors to leverage appropriate investment factors to reflect changes in market behaviour over time?
Tindall: For me, it’s almost the opposite. We are trying to find ways of constructing portfolios that we believe add value overall, such as improved risk-adjusted returns. So almost by definition, what we’re not looking for is something that you have to be in and out of, to make it work. It’s not a timing thing; it’s a strategic repositioning of the portfolio. That said, investors are always concerned about whether now is a good or bad time to invest, although that should be the same question for any investment.
Morgan: Yes, a smart beta allocation shouldn’t be short-term. From a trustee perspective, it starts with looking at what the objectives of the scheme are – such as a more stable funding ratio, say – and also the investment beliefs to see if smart beta fits in.
I think factor timing poses the same problems as timing in asset allocation, or tactical asset allocation. There’s no real evidence that people can do that and generate extra alpha, although obviously a lot of people do try. Of course, all fund managers are purporting to be able to do this through DGFs [diversified growth funds] and now through factor timing too, but I’m quite sceptical about their ability.
Caddick: We should determine what we mean by market timing. Many would probably agree that it doesn’t work. In my view, a lot of smart beta strategies give tools to the active manager and could be used both strategically and tactically. But our view here is that tactical means a six-to-12-month view and also means being able to capture, or strip out, certain elements of a traditional index, or trying to capture a particular target factor. Personally, I think value can be added, but not over the more extreme short term. It’s about trying to capture certain trends that you believe might play through.
Cassin: I very much agree and we see a variety of needs from different clients, most of which at the moment are centred on adding value from a strategic, medium-term perspective. But others, such as fund managers, are also asking for single risk factors that they can play with, whether it’s tactically or medium-term. We’ve launched ETFs on single factors to serve this purpose.
Morgan: A recent development has been diversification across different strategies. A smart beta investor combines, for example, value with low volatility to get a greater smoothing out of the impact of these strategies. After all, the strategies can potentially underperform for reasonably significant periods of time. This is about establishing portfolios with equity factors on a long-term basis, and then identifying which economic cycle we are in, to then possibly investing tactically in these single factors from an entry-point perspective.
Tindall: In general, most of our clients don’t do market timing in traditional asset classes, so it seems inconsistent to say they would want to with smart beta investments. Having said that, I get more questions about whether now is a good or bad time for smart beta strategies than in traditional investments. It may be that because they’re not traditional strategies, people feel they’re going out on a limb – regret risk is higher.
Morgan: But I think it’s legitimate to look at smart beta entry points. Also, I think you could view it as an active smart beta strategy because, inevitably, there’s always going to be comparisons with the relevant traditional market-cap weighted indices. It’s an active strategy, but with passive implementation because it’s rules-based and transparent.
Trottier: The ETF market is the visible part of the iceberg. In the US, one-third of the smart beta ETF market is just dividends. People understand they can’t outperform in every market and so they want to diversity to meet their downside risk when a certain factor is not doing well. There is an increasing number of multi-factor or multi-weighting schemes, because people are looking for diversification through a few factors.
Tindall: Our mindset is towards a one-to-five-year time horizon with a semi-strategic rather than tactical asset allocation approach. But with alternative factor-tilted strategies there are more difficulties because almost by definition, they’re less macro-sensitive. Having little macro-sensitivity is a good thing, but it makes it difficult to then align that to your views about the way the world is developing.
Another point is that with smart beta you have a very diversified starting point. It means, therefore, that you then have to be highly confident in your view when you change your allocation because you are moving away from the high level of diversity that you started with.
Morgan: Yes, and the problem comes if it hasn’t been explained properly to the trustees that a single factor strategy can underperform for perhaps three years. Three years is a natural time horizon for trustees to change their active managers. But in the case of smart beta, because the fees are a bit cheaper and there’s a little more ownership, as long as things are properly explained right at the outset when investing, then trustees shouldn’t really start panicking.
Caddick: As a buyer, we think of strategic beta as being effectively our reference benchmarks. So, even if we have built those composite benchmarks ourselves, that’s what we consider as strategic. And at present, we do not have any non-traditional indices within our strategic benchmarks, other than outcome-based. That’s not to say we don’t think they’re worthwhile, but that’s just the current state of play. So, by definition, any positions that we take within those will, theoretically, be tactical. I consider tactical to be different to market timing. I agree that people cannot consistently time markets, but I consider market timing to be sub-three months or so, and we would typically invest on a tactical basis with a six-to-12-month view.
For our outcome-driven portfolios or, typically, total return and moving into the more absolute returns, that’s where it becomes more interesting for us, because we will typically not have a strategic benchmark but rather a reference outcome. And that’s where we can use smart beta more strategically. Otherwise everything we’re going to invest in is an off-benchmark position.
Funds Europe: How would the panel describe smart beta product creation in recent months? Has it risen exponentially over recent years? Are providers managing to distinguish themselves, or is the market being saturated as ideas get duplicated?
Weithofer: It’s a global topic, so there’s no kind of local flavour to it. There has been quite a lot of development on the equity side, where single equity factors are now the building blocks for multi-factor portfolios. We have also developed fixed income offering exposure to quality-weighted sovereigns. That will be one of the next big topics.
Trottier: There has been a high level of growth but I don’t think it’s saturated. The area where we are seeing the highest creation is multi-factor, multi-weighting schemes. In this are there is no duplication: each index or product provider will bring a new solution to the market and this fits, I think, with the expectations of a lot of investors for smoothing the performance coming from factors and multi-factors.
Cassin: I think there is an element of saturation. We have identified over 350 factors that have been written about. We call it the Factor Zoo. We have put a lot of effort into multi-factor strategies where we see increasing demand. We also believe that fixed income smart beta strategies will become ever more popular. With fixed income it seems there are two schools: fundamental and risk-based strategies.We are leaning more towards the risk-based strategies. If you want to manage a proper risk-based strategy on fixed income indices, research and experience are essential because the identification of robust risk measures is complex.
Morgan: There has also been a proliferation in terms of the different definitions of style or factor. Value is being defined in all sorts of different ways and so is quality. People are again data-mining and back-testing to see which variant works best.
Of course, there has been a proliferation in products, with a lot of ETFs launched on the back of smart beta. And, as I said earlier, many active quant managers are now reinventing themselves as smart beta providers, too.
This all means that careful research is required.
Tindall: There has been a lot of research on many factors out there, though it’s not necessarily that all or many of them are long-term strategically robust or relevant for the future. The ones that might ultimately be useful are significantly less than the 300 factors. We’ve seen a lot of product proliferation, but not across all the 300. It is the ones that have been available for a long time, such as quality, low volatility, maybe size and perhaps to an extent momentum. For example, everyone’s got their own slight twist on the way of defining low volatility and putting the portfolio together.
Funds Europe: Which smart beta solution has most caught your eye in the past 12 months? What was it that interested you?
Morgan: If you’re doing a single factor approach, you might want to try and get a fairly explicit exposure to a factor such as value; and then you want a weighting scheme which provides some diversification, and then you’d have a single factor smart beta product. And then if you have one for value, one for low volatility, you can combine those into a multi-factor approach. That’s one way of doing it. But the other way is to have multiple screens in a fund. There may be some advantages in doing that, because sometimes you’ll avoid trades that might be similar in two different funds, value and low volatility for example.
Tindall: I would highlight strategies across multiple asset classes and in a long-short format. We are doing that with several strategies – for example value and implementing across countries in equities, currencies and fixed income; these are long-short market neutral-type strategies, but still very rules-based.
Morgan: Long-short is sophisticated and gets into where clients are considering hedge funds. If there are smart beta strategies that effectively capture a lot of the factor exposures that hedge funds try to capture, in a cheaper way, then that may be the way forward, for a number of reasons.
Trottier: In the past 12 months my attention was not caught by any fixed income smart beta. There have been some products perched in the market but it has been disappointing. Either it was the reshaping of an old story, like GDP-weighted, or it was centred on fiscal strength.
Tindall: We’ve been doing some work on, effectively, equity-type thinking but for bonds. It’s the similar idea that you can apply momentum, value, or carry and size, to a degree, in a bond portfolio.
Now, there are more practical problems in bonds, such as liquidity. And of course, momentum doesn’t really work very well in investment grade credit, where there’s only a limited price movement. But it works more in high yield.
To me, there is definitely an interesting strand of research here.
Cassin: I would agree. For us, this is the time to develop our thinking and product range because we think that the time will come when these strategies will be very successful. We’re at a stage in the fixed income market where traditional fund management will be struggling, and I think there are some interesting cost-efficient answers that can be offered by smart beta solutions.
Funds Europe: Last year, Edhec-Risk Institute said that smart beta investors were taking considerable risk because index promoters were not documenting or explicitly controlling risks within their offerings. The academics called into question the robustness of the index performance. Does the panel feel these concerns still apply?
Cassin: Transparency is key for us. We agree with Edhec Risk and share their concerns but anything we do, whether on our proprietary strategies or when we select indices on which we launch ETFs, requires a huge amount of research and due diligence. We then publish our methodologies. The analogy with open-source software should become the norm.
Trottier: Investors may have seen research about the fact that value is outperforming in the long run – but the first point is about which definition of value is being used.
And, secondly, when we talk about multi-factor, then the way the factor was designed and the consistency in designing the factor is at stake. If you use, for example, two years’ history to design one factor, five years with another one, or if you use a risk model to compute your min-var, well, maybe there are some risks behind that. The issue is to be consistent.
Morgan: I think one of Edhec’s issues was transparency, and I think they would say that if it’s not transparent and rules-based and can’t be replicated, then it probably isn’t smart beta.
The other issue is robustness, which is about whether factor returns will persist? There’s a lot of research going on in terms of different factors and variations on the definition of factors, data-mining and back-testing.
The question is about whether a factor that’s back-tested on certain historic data appears to have worked for 20 years, but only worked because it was just pure chance that led to the results.
Despite there being about 300 possible factors, there’s probably relatively few factors in reality. Value, low volatility, momentum, they are out there and it’s important to perhaps focus more on those and not get too caught up in new factors.
Weithofer: With ETFs, you can have access and see what is in products on our website on a daily basis; you could get full index methodology by an index provider; so transparency is definitely not a topic, at least on our side.
Trottier: There are a lot of index providers or proprietary strategies that really tend to give the transparency of their former performance, their former portfolio weightings, so I’m not sure that transparency is not a subject.
Funds Europe: Where next for smart beta? What can we expect in the 12 months ahead?
Morgan: Multi-factor investing – the combination of different factors to get a smoother, alternative risk premium-return stream, will progress.
Weithofer: For us, strategic beta is strategically a growth area for the business, not just for our clients. I anticipate 15-20% market growth over the next couple of years.
Cassin: Smart beta has now established as a building block of institutional portfolios. Also, fixed income and multi-factors will grow, and we expect there will be more choice for investors with single factors ETFs, and multi-factors, coming in all different shapes and forms. Price is likely to go down again, making it even more appealing to investors.
Trottier: Smart beta will continue to impact on the asset management industry in terms of growth and innovation. This is good timing for the industry because the industry has been suffering due to the financial crisis. You will see that most players, not just in the ETF space, have reduced their offerings of open product customisation. Cost monitoring was a big focus between 2008 and 2010, but we are again now much more in expansion mode. The question about saturation will be very relevant next year.
Caddick: Proliferation and innovation go hand-in-hand for now, but I think over the next 12 months there will be continued growth. What we might see is providers finding better ways of defining their area, their product line-up, and what it really stands for. I suspect also that clients, given the vast and expanding range of strategies and products, are going to partner up more and more with providers as a more efficient means of accessing their target positions.
Tindall: I agree. There’s a lot more to go, even if people are somewhat concerned about hype and overinvestment. There are a lot of avenues that could develop, but for me a key one would be long-short hedge fund-like strategies captured as beta.
Costs will also be given more consideration as people think more about whether smart beta is active or passive. In turn, I think this will change the alpha side somewhat as people work out what the right fee should be given embedded beta exposures.
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