The use of smart beta strategies continues to grow, says our expert panel, but do investors understand what they are and when they should be used?
Himanshu Chaturvedi (managing director, Cambridge Associates)
Tom Farrell (investment consultant, Lane Clark & Peacock)
Adam Laird (head of ETF strategy, Lyxor)
Jose Garcia-Zarate (associate director, passive strategies, research, Morningstar)
Liz Wright (senior ETF sales specialist, Vanguard Asset Management)
Funds Europe – Can smart beta strategies work for retail investors, or are they mostly the preserve of institutional investors?
Liz Wright, Vanguard Asset Management – If you understand Vanguard’s philosophy, it’s all about the retail investor, so we believe that whilst institutional investors are currently the ones that are taking advantage of factor-based strategies, the retail investors will definitely benefit. There are four reasons for this, and this is because they have return enhancement, risk reduction, replace high-cost active, and they have a portfolio completion within them.
Adam Laird, Lyxor – I’d say it’s about taking indexes and putting them as a way of achieving investors’ aims, rather than simply replicating a market. That’s what it comes down to. I think it’s about taking us away from the traditional index, which was full exposure to every company within the market, and saying, ‘Can we rearrange this index in a way that makes it achieve an aim?’
For example, risk reduction, as you said, or boosting your returns or achieving higher income than a portfolio. For me, smart beta is index-managed and it’s moving us away from conventional, traditional market-cap.
Jose Garcia-Zarate, Morningstar – In a way it’s actually doing what active managers have been doing for decades, but doing so, or delivering it in a rules-based basis and at a lower cost.
It has been facilitated by impressive developments in technology and indexing that wouldn’t have been possible perhaps ten to 20 years ago. But now it’s fairly straightforward to deliver these active-like strategies within an ETF wrapper and still call it a passive fund, because it’s rules-based and it’s obviously going to be replicated, it’s not going to be as active as an active fund: it sits in between a traditional market-cap and what active managers have been doing for generations.
Himanshu Chaturvedi, Cambridge Associates – Is an understanding of the exact construction of a smart beta strategy a prerequisite for individuals to invest, whether we can define it or not?
In the end, if you boil it down to its basis, smart beta is a sub-set of stocks. Investors have been happy to hold active managers in the past – why would this not be appropriate, by that logic?
Some of these strategies are extremely difficult to understand, for institutional investors let alone retail investors. So, the question is not whether the retail investor should benefit; why shouldn’t they? Of course they should. The question is, ‘How do you deliver these strategies and where do you place the educational part?’
Tom Farrell, Lane Clark & Peacock – I think the definition of smart beta is quite simple: it’s just a rules-based approach to equity investing that is different to market-cap. That’s very broad, but within that the most popular strategy right now seems to be this idea of factor investing, whether it’s value investing, low volatility or whatever. I think that the smart beta funds that exist can be attractive and they’ve got very good characteristics for a retail investor - they’re very liquid, ETF structures are available, they generally incur low fees and so on.
The other point to make is that these funds are very scalable, so when a fund manager has launched one of these funds for institutional investors, there’s no reason why they couldn’t go out and release it into the retail market. There are lots of incentives here for asset managers to go away and put those education pieces together to try and engage with the retail market. I think everything is in place, but I do believe that the education piece may be one of the biggest barriers.
Funds Europe – What function do smart beta strategies perform in a diversified portfolio?
Farrell – I think it would vary massively across different types of investors. So, for a defined benefit (DB) pension plan, the equity portion of its assets is normally seen as the growth engine or the part of the portfolio where you place the highest expected return, so a smart beta strategy would be considered to fall within that, and that would be the main function there. From a defined contribution (DC) perspective, it is very similar: for members in their early years, you would expect a high level of exposure to equities and a smart beta strategy might be appropriate for that: so very much growth-orientated functions.
Other functions might be diversification, for example where investors already have exposure to passive market-cap equities or active managers, they might want to complement that with some sort of factor portfolio to provide some level of diversification. Other examples might be if you’re de-risking, you might look to a low-volatility portfolio, because you might think that this is less risky than just the standard market-cap passive portfolio.
Garcia-Zarate – That actually is very telling, because I think it goes to the heart of what the use is of strategic beta. It’s not a magic solution. There is cyclicality on a lot of the factors, and so it’s not something that you can perhaps buy for the long term. Factors will go through very long periods of underperformance relative to market cap. So that basically, again going back to the issue of education, how do you make sure that investors, whether they’re retail or institutional, understand how to incorporate these factors and understand the cyclicality and the nuances of factor investing within the portfolio? It is not going to play a core role in a portfolio, it’s going to be more peripheral in a way.
Chaturvedi – Institutional investors tend to think in the equities world in terms of active risk and that’s usually relative to the opportunity set, which is the market-cap benchmark and smart beta strategies are just another brand of active strategies. They have certain characteristics which are useful – they’re lower-cost, they are in a sense more predictable because you know the flavour of the strategies and they have less behavioural risk because with a traditional active manager, there’s always a chance that there’s going to be a style drift. There’s always a chance that the idiosyncratic risk overwhelms any style factors within the strategy, which may be desirable or not, but it’s just a different combination of risk factors from, say, your market-cap passive versus your fundamental active.
Wright – Going back to what I said at the beginning, smart beta investing serves four purposes: it is about return enhancement, risk reduction, replacing high-cost active, and adding value to the portfolio completion. You wouldn’t use just factor funds or factor ETFs or smart beta ETFs completely in a portfolio, but you’d use a blended approach to achieve the overall objective of a client’s portfolio.
Laird – As I see it, if I just want general returns, I’ll stick with traditional index funds or a traditional whole or broad market approach, because I still think that in general cases that’s the simplest way to get it. When it comes to risk reduction, there are times – for example on the run-up to retirement – when traditionally people have converted a lot of money into cash. A lot of people don’t have enough money in their pension that they can afford to take all the risk off the table, and that’s something that a minimum volatility strategy can do. In institutional cases, there will be strategies that want to leverage themselves towards value or towards quality stocks or will want to tinker around the edges in these things, and I think these are cases when smart beta can work quite well.
Funds Europe – Do you expect the amount benchmarked against smart beta indices to continue to rise, or has factor investing reached its peak?
Garcia-Zarate – I think actually we’re in the early stages of the growth of smart beta. We at Morningstar actually call it ‘strategic beta’ as we don’t like the term smart beta. There is still massive room for growth, actually. The global ETF market is about $55 trillion give or take. Looking at the stats in the US, for example, strategic beta or smart beta is only about 20% of assets in ETFs, in Europe it’s about 8%. We’re still talking about very small quantities here compared to the wider investment opportunity set. There is definitely room for growth, and mainly because I would think that, particularly when it comes to market-cap exposures, it’s fairly crowded in some respects. There’s plenty of choice and plenty of providers actually offering these very plain vanilla market-cap solutions. So, you get a lot of ETF providers now coming into the market in Europe, and they’re not going to be launching a FTSE100 fund, although they might in future, because obviously you need to have the whole range. But their first efforts are likely to be on strategic beta.
Wright – If you’re too late to the party, you’ve already missed the boat, so you need to come up with something first-to-market in order to get an opportunity to actually compete within the space.
Firms will have their own approach on how they decide to do their smart beta strategy, so everyone will do a factor base differently and that’s what’s going to increase the opportunity. So you’re not just going to go into a single smart beta factor-based investment type product, you’re going to look at the opportunities, at how they differ, how they look in your portfolio and how they complement what you are trying to achieve. Everyone’s going to have a different style, so the opportunity for further development is going to be in the construction.
Laird – As people start to take their objectives away from the traditional active manager and towards passive strategies, I think we will see growth, but I’m not sure that it’s quite the way that the growth has come up until now. There’s probably a review of a lot of those strategies that people have looked at in the past, maybe asked, ‘Has some of this just been backtesting?’ and actually trying to say, ‘Now that these things have three/five/seven years’ track records, have they actually met their aims? Are they sticking to their promises?’
Farrell – One potential key barrier to all of this is around performance. There’s been a flurry of product launches in the last three or four years and there are still a few more being launched. I think in three, four or five years’ time, if the track records don’t start coming through, I think you’re going to see a lot of investors saying, ‘Hang on a minute, this isn’t what I thought I was getting.’ There could be large outflows if these funds don’t actually pan out in the way that people expected. Ultimately, I do believe the market will continue to grow but this may be a potential key barrier that we might stumble across in the next three to four years. The other possible barrier is UK DB pension schemes de-risking. We expect most DB pension plans to have little exposure to equities in the next ten to 15 years (so long as funding levels improve as expected over the time period).
Chaturvedi – If you look at what space factor-based strategies are growing into, they’re taking share from active, which is still a dominant part of the market. In particular, the core-type active strategies, which is where all the closet indexers tend to reside. As long as that’s a significant part of the market, there’s a great addressable market for factor-based strategies to go after.
Second is the pure passive strategies as well. People realise over time that, ‘I have taken a sure loss, i.e. below market-cap index performance. If I am really investing in equities, should I not have more risk appetite than just investing in a passive index?’ That question will get asked. Today cost is the dominant narrative, and it may well be for a few more years, but at some point, when we go through a market cycle that disrupts this pattern, people will ask different questions. But for the moment, there is a lot of space for these strategies to grow into.
Funds Europe – Is it right that the market-cap index should be the dominant benchmark?
Laird – There’s been a conversation at the UK’s Investment Association about benchmarking for groups of funds and whether or not peer group benchmarks make sense, or funds should be assessed on the market-cap index, or whether or not it should be an index which is specifically for the aim of the fund that’s out there. I see a lot of evidence that market-cap indices shouldn’t really be the benchmark, the yardstick for performance measurement. I haven’t seen a lot of evidence of that changing yet. We know the vast majority of money flows into traditional benchmark index funds. In the active world, there seems to be a preponderance of funds that remain benchmarked against a standard market index. So, I think we’re still a way from having that change.
Chaturvedi – Benchmarks are all about what decision are you trying to evaluate? Are you trying to evaluate the decision to select that manager? Are you trying to evaluate the style decision that someone else might have made that decision, i.e. selecting that type of manager versus some other style? It’s all relative to that, but when you zoom out to a higher level, just equities as a whole, I don’t see very compelling reasons why the market-cap index shouldn’t be the dominant benchmark, because that represents the entire opportunity set. Someone could buy the whole market and they would have to proportionally put more in Apple and Amazon and Google than they would in a small-cap company in the UK.
Garcia-Zarate – I completely agree with that. I think there are two separate issues here. One is, what is the market actually? I think we all agree that market cap is a fairly intuitive and straightforward measure of what the opportunity set is. Another issue is, how do you measure the performance of a selected group of funds against something else? That’s a separate issue. But the predominance of market-cap, in a way, is like questioning that the Earth is not round. Market-cap is the very straightforward measuring of the market, and so it’s the central tenet of our measurement. After that, you create additional measurements, but there is a good reason why market cap is predominant – it’s the market itself.
Farrell – I completely agree. It’s the only index that you can replicate, and there’s virtually no risk of underperformance, there’s very little transaction costs, it’s simple and it’s low-cost. It does have its limitations that are very well documented, but I think the advantages very much outweigh those.
Wright – There are so many indices out there that give you the opportunity to be quite specific, so it comes down to the individual and what they are trying to achieve. Like you said, you have the FTSE All-World index, or the FTSE 250, you can get quite granular and say, ‘Actually, I don’t want to compare myself against the FTSE 100 because it doesn’t really deliver what I’m looking for, it’s not really matching up against what I’m looking to deliver, I want to compare myself against the FTSE 250.’ So it depends, you choose the index that suits you to be able to compare yourself against and what you’re trying to achieve.
Funds Europe – What’s been the most interesting smart beta solution of the past 12 months?
Garcia-Zarate – I spoke to my colleagues in the US yesterday, because sometimes a product development cycle in the US is much more advanced than over here. I asked them: ‘I want to know what got your attention, either because it’s truly innovative or really wacky,’ and they said they didn’t care about wacky things. I think what we’re seeing is multi-factor strategies which are rules-based and you see a lot of evolution in the construction of these multi-factor indices. We come back to the issue of cyclicality and the fact that some of the factors may go through long periods of underperformance, so it’s even a step closer to active management in that respect. They were referring to some sort of dynamic multi-factor funds that were launching in the States that are half a step removed from active management in a way, and that seems to be the main thing that is going on at the moment.
Chaturvedi – It sounds like the question is focused on the product side. If you look at the broader market, what this is doing, the prevalence or the growth of smart beta solutions is prompting interesting adjustments from active managers, because for them, anything where the rules are put out there and followed blindly is an opportunity to exploit. I’ve seen active managers try and deconstruct smart beta products and figure out: ‘OK, what distortions is this creating in the market? Whether it’s a risk or any opportunity to my strategy?’
Previously people didn’t dissect their performance by these factors, and now they do, and they think, ‘OK, this is what’s going on in my holdings here, how can I take advantage of it?’
Ultimately, if we agree that market-cap indices are the dominant benchmark, this is a zero-sum game. Whatever excess return smart beta captures is coming from somewhere else, or whatever they don’t, as in whatever losses they make, they’re going to come from somewhere else too.
Farrell – You could make a similar argument for low volatility. For the factor to persist, it would ideally have a risk-based argument attached to it, which you might expect could carry on in the future. If it has a more behavioural argument attached to it, then there is a higher chance of it not persisting in the future (should investors correct their behaviour). So whether it has performed well is one thing but whether it’s going to continue to perform well in the future is another.
Funds Europe – What development do you expect in smart beta between now and the end of the current decade?
Farrell – I think it’s going to be multi-factor with ESG integration. Smart beta and factor investing is mentioned in the press a lot, it’s getting a lot of attention, lots of roundtables and conferences and so on. The other one is ESG.
The government is clearly keen on ESG, they recently surveyed the 25 biggest pension schemes in the UK about whether they considered carbon risk and implemented any mitigation strategies.
I think factor investing with ESG integration can be quite a neat solution. They are two investment styles that can work quite well together, and there’s been a few product launches. There’s a few managers in the background designing funds to bring to market and they’re starting to have conversations with clients and consultants.
Garcia-Zarate – I’ll go for fixed income, mainly because it’s very challenging. There’s no real consensus as to actually where the factor investing can be applied or actually exist in fixed income, and there are various different views about it. That actually goes to the issue of a market-cap approach to fixed income: it’s often not the most rational way to invest in a bond portfolio. There is a distinct lack of academic research on fixed income factors, but that’s not stopping index providers and ETF providers actually looking into the area. There are a few products coming here and there and I think that that could be an interesting space to watch.
Laird – I don’t think it’s going to be a new product, I think development is probably going to be in the way that investors select smart beta and implement it into their portfolio, and I think that actually the world of robo-advice has done a very good job at making simple portfolios available for people. A lot of the big users of smart beta are private banks and looking at more bespoke solutions for individuals who have needs that can’t come through from a simple portfolio, and I think what we’ll probably see is more unique and personalised ways of building those portfolios and using smart beta as part of that. It’s the user interface, if you would, that I’d like to see shaped up, rather than a suite of new products.
Wright – The fixed income space probably has the most opportunity, and we’re seeing it now where people are looking into fixed income and how they can invest. The more it gets into the detriment of, ‘Where am I going to get that income?’ they will look for more factor-based investing. The only challenge I see with that, and this is one of the biggest challenges, is track record, because whilst you’re going to look at factor-based investing, you’re going to look at various points such as track record and how is it going to stand up to what you’re looking to get out of it?
So, there’s some challenges there and there’s a lot of innovation currently taking place.
Chaturvedi – There is definitely going to be a lot more choice because smart beta lends itself to creating many flavours of the same thing. Within passive or market-cap passive it’s just a simple scale game, I don’t think smart beta is quite like that. It is scalable to an extent, because the more you constrict your universe as you go from the entire market-cap universe, the lower your scalability. Also, the more your strategy dynamically trades, the less scalable it is: every quarter if you have 40% turnover, that limits your scalability. So, we’ll see a lot more balkanisation of the market. We will see the same techniques being applied in more granular ways.
©2018 funds europe