Funds Europe asks those in the know about the burning issues facing the industry, such as how will smart beta affect fund management and what are the risks?
Tom Caddick (global head multi-asset solutions, Santander Asset Management)
Olivier Cassin (head of UK institutional sales, Lyxor)
Jamie Forbes (director, asset owner markets, EMEA, Russell Indexes)
Neil Morgan (senior pension trustee, Capita Asset Services)
Philip Philippides (head of index & ETF sales for UK and Ireland, Amundi UK)
Phil Tindall (director, Towers Watson)
Funds Europe: What impact will the development of smart beta have on fund management?
Tom Caddick: Some people talk about smart beta versus dumb index, and use that as a reason to suggest that smart beta is the answer to everything. This is dangerous. Smart beta is an interesting way of controlling asset class exposure. And this will continue to be more sophisticated but probably nothing more.
Jamie Forbes: It’s absolutely true smart beta will serve to separate those active fund managers that are truly skilful at generating alpha consistently above those exposures, because investors will realise that they can get access to those exposures in a more cost-effective way and it will hold those managers to a higher standard.
Caddick: It has been an interesting challenge for the industry, that those who have purported to be active managers can in some cases be replicated through an indexed approach.
Neil Morgan: There has been quite a large take-up already from large pension schemes. It hasn’t quite filtered down to small- to medium-sized schemes yet, but it will do gradually. There’s been a proliferation of products from asset managers, from index providers and from ETF providers. There is a recognition that market-cap indices are inefficient and by accessing smart beta strategies you can get exposures to more targeted risk factors.
Olivier Cassin: Smart beta techniques challenge active managers and help separate the skilful ones from the lesser ones. They enable tactical asset allocation in a way that is much easier, much more flexible and more liquid. They have also revolutionised the traditional asset allocation framework by asset classes, regions or sectors by proposing a more robust allocation by risk factors.
Forbes: Probably the natural follow-on to that is that active managers will start to shift more towards very high active share, higher risk and then investors, hopefully, will benefit from that and can spend their risk budgets more effectively.
Morgan: One of the effects has been on active equity fund management. Previously active equity managers had these implicit tilts towards value and small cap and they were outperforming but now there is an explicit recognition where the outperformance is coming from. So now the smart beta industry has come in and you can get access to these factor exposures much more cheaply and much more efficiently by accessing smart beta strategies. So the active fund management industry needs more of a focus on pure stock selection.
Forbes: We’ve definitely seen the adoption of smart beta starting with those larger asset owners. We just published a survey of about 180 asset owners globally and found that 46% of those asset owners with more than $10 billion in assets already had a smart beta allocation. As you got smaller down the size scale, those percentages became smaller.
Caddick: Trustees have got to be clear about what they are trying to achieve because smart beta strategies in isolation have long periods of underperformance. So without active intervention it is a long-term strategy of, say, five or ten years time. So trustees, right at the outset, have to be very clear about what they’re trying to achieve – return enhancement, risk reduction – and also be very aware of possible periods of underperformance over time.
Phil Tindall: It poses some interesting challenges and opportunities for the fund management industry. We have already seen a flood of products under the smart beta banner, particularly in low volatility. Not all strategies could be described as beta, with features more associated with alpha – for example, high turnover or less transparency. The recognition that some alpha can be captured as beta is a challenge to the fees that managers charge. Genuine and consistent alpha is hard to find, and therefore valuable. But managers should only charge beta-like fees for beta.
Philip Philippides: Smart beta is an evolution within the asset management industry. Not all smart beta is new, but strategies have evolved as fund managers developed systematic approaches to outperforming benchmarks under different market conditions. Many strategies that fall under this banner, such as minimum volatility or equally weighted stocks, have been around for some time. The industry is bringing new products and strategies to the market but also using tools, such as ETFs to incorporate into their allocations.
FE: Can smart beta indices be used as benchmarks in asset manager selection?
Morgan: Consultancy firms have got very large research departments and they have been focusing on active equity managers but now they’re having to be a little bit smarter at drilling down into the performance of various active equity managers, looking to see whether, through smart beta, they can actually access those risk factors more cheaply and efficiently. If you want a value tilt it’s a choice between an active equity manager who has a value bias, who might outperform for you, but there’s a high fee associated with that, or you can go to a smart beta strategy, which is cheaper and is likely to outperform over the longer term.
Forbes: It is similar to the 1980s when style managers, like active value managers, started to be held to a value benchmark. We’re just seeing those benchmarks move away from being cap- weighted to, now, non-cap weighted smart beta indices. They’re the exact same exposure and betas that they’ve always been. It’s just an evolution of how beta is being captured.
Philippides: Smart beta can be used as a benchmark if it meets an investor’s objective. However, market-cap weighted indices have the benefit of being well adopted and having well-understood methodologies, whereas smart beta is more recent. But there are some sizable pension funds that have moved to strategies such as minimum volatility and I can envisage that this trend may expand.
Cassin: Smart beta indices are very useful to better understand investment strategies and refine performance attribution. Will they supplant traditional indices? We have seen this happening with some sophisticated investors but most likely, active, passive and smart betas will coexist.
Morgan: It’s difficult to move away from traditional market-cap weighted index funds as the benchmark for evaluating smart beta performance because they have been around for so long and there’s so much money invested in them. Some large pension schemes and sovereign wealth funds have tried to dispense with market-cap and impose a smart beta as a benchmark but stakeholders are looking at the equivalent market-cap benchmarks. So it’s inevitable that smart beta strategies will be compared with equivalent traditional market-cap indexes.
Tindall: Greater recognition of strategies or processes that can be reproduced as beta is an important lens when assessing active management. This has an impact on our view of how proprietary or differentiated investment manager processes are. Similarly, the fees we should pay need to take into account the beta exposures we have. In equity long-short hedge funds, for example, fees need to be considered after taking into account net market and other beta allocations, as well as the gross exposure – combined long and short positions – for alpha security selection.
FE: Edhec-Risk has said that smart beta investors are taking considerable risk because index promoters do not document or explicitly control risks within their smart beta offerings. The academics called into question the robustness of index performance. How does the panel respond to this?
Forbes: As the representative of the index industry here, it is true that those first smart beta strategies didn’t explicitly control for risk, but I’ve never met a [smart beta] investor that didn’t understand that what they were buying was different from the market-cap index. It was going to have tracking error and it was going to have some degree of active risk. That being said, there are recent innovations in factor indices that do take a more active-risk aware approach and explicitly control for the risk of underperforming by tilting efficiently towards those factors.
Tindall: It depends on how focused the investor is on relative performance to market-cap. In a relative return world, there are lots of potential risks that can arise from over or underweights to a stock or sector versus the market-cap. But this pre-supposes that market-cap is the only or best starting point. In a fundamental or absolute sense, risk is about the riskiness of the stocks held in a portfolio, and their concentration. It is quite possible to have a strategy that has lower risk, or at least no higher risk, than market- cap in an absolute sense, but has a high tracking error because it’s very different from the market. True risk isn’t tracking error.
Philippides: If I’m interpreting it correctly, they’re looking at the traditional benchmarks and saying that there are inherent risks because of the biases in size or in other kinds of factors. I’m not in a position to comment on all the different kinds of index providers as there are diverse methodologies and a lot of research that goes into creating indices. What I would say, is that Edhec has brought to market a suite of fully customisable smart beta indices with a consistent methodology, which is currently unique. This allows investors to choose the geography, the weighting and the risk tolerance to a benchmark or strategy that is most relevant to them.
Morgan: In the early days of smart beta, it was about alternative indexation, alternative weightings, better weightings than market-cap, and better risk adjusted returns. There wasn’t that much focus in the early days, in terms of where the outperformance was coming from. Now, of course, there’s been much greater analysis and the outperformance is coming from tilts towards these specific factors, such as value, small-cap, and low volatility, for example. So Edhec’s saying, well, actually, rather than having these implicit tilts, which you might have two or three of, in a fundamental index, for example, why not have more explicit tilts towards risk exposures that you actually want in your fund? Diversification across different factors will also give you a little bit more risk control because they’ll be outperforming or underperforming in different ways in different parts of the economic cycle. Then, of course, there’s tracking error, which is obviously very important. Trustees need to be very aware of the potential underperformance. One of the things that Edhec and other institutions have done is to say, well, actually, choose your factor exposures quite carefully and put your weighting scheme in, but also impose some sort of tracking error constraints on top of that. If you’re constraining the tracking errors, you’re not getting the maximum benefit possibly, but it’s a trade-off between outperformance and also being able to sleep easier at night with reduced tracking errors.
Cassin: With regards to accountability and transparency, the answer is relatively simple. Investors should go with the authors – the people who have done the research and have published it. The authors are better placed to explain performance or underperformance further down the line and be accountable for what happens.
They are less likely to say, well, it’s a model-driven strategy, talk to the index provider!
As for robustness, not all strategies are designed to be robust. Some target specific premia, other are more risk-based are more likely to perform consistently across region and market regimes.
So the main risk for the investor is a risk of model, more precisely of selecting the wrong model for their fund.
It is essential to choose a strategy that fits investors’ objectives: strengthening downside protection, reducing volatility or increasing performance of a traditional passive pool with a tracking
Caddick: Certainly in the early days, some were designed explicitly to generate a more attractive risk return mix whereas, as it’s evolved, the relative or absolute risk element has become less of a focus. Some of them have been more returns-focused, and tracking error is certainly not the ‘be all and end all’. Some of the strategies that have come through have been more returns-focused, and maybe the industry has fallen short in explaining the relative risks inherent within that.
FE: In the current market cycle, which smart beta should investors be investing in?
Caddick: From a strategic point of view, smart beta plays into that value and small to mid-cap place, which has traditionally, over the longer term, performed better than a market weighted index. So you could argue smart beta quite often plays into that style space, much like certain types of active management have been able to outperform by exploiting this area.
Now probably isn’t a great time to be going down a market-cap scale or going up the value scale. So it possibly isn’t a great time to be playing off some of those themes but it does go back to what is the correct timeframe for investment. If you’re using it to build your strategic mix within a portfolio, then what you’re looking for is a longer term. If, however, you’re going to use it more tactically, to play and control the sort of themes and styles you’re using, then it isn’t a great time to be investing in small-cap.
Philippides: As everyone knows, it is very hard to ever really establish where you are in the cycle. If you have a strong conviction, however, you can find the right strategy in the market to implement it. If you don’t, then you need to be more diversified or have some way of covering the risk that you’re taking by selecting a specific strategy.
We are now seeing the emergence of multi-smart indices that combine and allocate to numerous factors that perform in various market conditions. These allow investors to invest in robust strategies over a longer time horizon rather attempting to tactically capture specific parts of the cycle.
Morgan: If you are looking to implement a smart beta strategy it is valid to some extent to look at the entry point but it’s not the ‘be all and end all’. If you’re diversifying across a number of smart beta strategies, the actual entry point of any one strategy is perhaps less relevant. This question also talks a little bit to the value of tactical factor timing. I’m not a great believer in tactical factor timing. It’s a little bit like tactical asset allocations.
There’s not a great deal of evidence that people can do it properly. So I would see smart beta more as a longer term strategic asset allocation, where the timing is of some importance but, if you want to mitigate the risk of that timing, then maybe you go into a number of multi factor smart beta strategies when you enter into such a strategy.
Tindall: We’ve spent quite a lot of time trying to think about timing or whether there’s a headwind or tail wind to these types of strategies. Assessing the signal to noise ratio is even harder in this space. It’s somewhat odd, in a way, that a lot of investors don’t do tactical allocation because many people tried it and found it difficult and gave up, but here they’re almost saying you should do more of it, when it’s actually harder to do it.
It is because the strategies are non-consensus, you want to feel even more comfortable about doing it. Some investors are more sceptical because there is the fear of strategies being arbitraged so they want to be really cautious about entry and exit points. That, in itself, still remains a very difficult question.
Forbes: It also requires a high degree of governance and resources to be able to do that. So, for a lot of investors that just do not have that level of resources or governance in place, then they’ll follow a lot of what Neil was talking about – let’s diversify that risk so that timing entry point and the ability to tactically adjust is less of an issue.
FE: What is the ideal timeframe to remain invested?
Caddick: It’s got to be a realistic timeframe of three to ten years. If people aren’t realistic on that timeframe, then they shouldn’t be looking to take on the risk.
Morgan: You have to explain to trustees very clearly what the potential underperformance of any particular strategy is. In a longer term strategy, there may well be significant periods when there will be underperformance of a reasonably significant amount. Traditionally, you give an active equity manager three years and sometimes it’s difficult to go beyond that. So it’s important, right at the outset, to impress upon trustees that if it does start underperforming not to press the panic button after three years or so. If you’ve got an investment belief right at the outset, that value is going to outperform over the longer term, then that should stay in place.
Governance is also important. The trustee board has to have the ability to decide on their investment beliefs and to take on board the idea of a smart beta strategy if that fits in with their investment beliefs. There are simple and complicated smart beta strategies. So there are active quant kinds of strategies at one end of the scale, where you have a greater complexity and trustees may not be able to understand those strategies completely.
Philippides: It is a relatively simple concept, that with a longer timeframe you reduce your risk substantially. Clearly, the problem is with all the news that investors get on a daily basis, it’s very hard sometimes to hold on to the longer timeframe and the risk that you were willing to take at
So if you’re looking for a shorter time horizon, then you need greater diversification and alternative ways to mitigate the risk that you don’t want to take.
Cassin: The timeframe has to be consistent with the strategy pursued. Short time frames can work for a tactical exposure to a specific premium but in most strategies such as equal risk contribution, a minimum three- to five-year holding period is recommended.
Forbes: It’s not the right question because it does assume that all smart beta is alike. The right question goes back to the investor’s objective and, therefore, what is the smart beta strategy that fits within their constraints and some of those constraints are going to be time horizon.
FE: Should smart beta indices be the correct option for measuring performance of active asset managers?
Tindall: We are recognising that there’s a space between traditional alpha and simple beta. That doesn’t mean to say you don’t use active managers, but you need to recognise that some of what they’re doing could be captured by a smart beta strategy. So in that context you could say some of the performance could have been bought at a cheaper rate. If a manager outperforms – good, but then I should really only pay alpha fees for the true alpha and pay less for the beta bit of it. We are extending the idea of beta from the days of equities and bonds to say there’s something else as well. I don’t know whether it’s necessary to define smart beta as an index benchmark as it leads to tracking type problems. That said, if you believe the smart beta index is a good starting point and you have an index hugging manager, then all I’m doing is transporting that hugging on to something better.
Unconstrained managers shouldn’t really be affected, but it’s still quite useful to say, well, actually, some of what they do could have captured through this beta, and make sure I don’t pay alpha fees for it.
Forbes: The traditional definition of benchmarks is that they represent the opportunity set of what a manager is investing in. So the right benchmark is something that’s an appropriate representation of that.
Morgan: Investment consultants have always had a large database of active equity managers. Within that universe of active equity managers, some have had an implicit value tilt. Some have had a small-cap tilt. Now, over the last few years or so, investment consultants have done a little bit more of a granular analysis, to weed out those which have got these various tilts. Now the question is if an investment consultant were to come to me and recommend an active equity manager with a value tilt, I would say the fees might be a little bit too high because I could get a cheaper and more efficient exposure to the value tilt through smart beta. So it’s a slightly different kind of conversation now.
Then, within the true active equity manager space, I might well pay for some pure stock selection, as long as they can demonstrate that added value. You still will have some active equity managers with a value bias as well as a small-cap bias.
They will still want to be benchmarked against traditional market-cap, but an investment consultant will say to them, we also want to benchmark you against a smart beta value index because that’s a fair comparison.
As trustees, we’d probably say, if this guy says he’s good at stock selection with a value bias, we also want to see a comparison against something which is a fairer representation of the universe he’s actually investing in.
FE: Is the market-cap index likely to remain the most dominant form of benchmark, and what is its strength?
Forbes: Its strength is that market-cap captures the aggregate experience of every investor and, therefore, market-cap is the output of investors’ actions, but it doesn’t necessarily follow that you should invest passively with market-cap. Just because it is the macro-consistent representation of the market, that doesn’t necessarily make it an efficient investment strategy.
Caddick: Yes, it’s not necessarily the best way and, if you were to design it from the bottom-up now, you might not design it that way, but it’s embedded in the psyche and here to stay.
Philippides: It’s broad and it’s consistent and it’s the methodology that everybody’s used. In that instance, it serves its purpose because people understand it and people are used to it. And when you look at alternatives, there isn’t a consistent methodology. It is the lack of a standard for any of the other kind of factor exposures.
Cassin: Market-cap weighted indices have also the largest capacity and the lowest turnover by construction. Having said that, we all know their limitations: they carry a high level of momentum and accentuate bubbles and risk concentrations at times. This is why very large Dutch and Scandinavian schemes have integrated a relatively high proportion of smart beta to their strategic allocation. Blending smart beta and traditional passive strategies is a natural trend which will gain momentum in Europe and the UK.
Morgan: It’s still going to remain a core part of most people’s portfolios because so many people are invested in traditional market-cap index funds already. But you are seeing that move towards investing in portfolios which give a better risk return trade-off, whether it’s diversified growth funds or smart beta strategies where you get a better risk return trade-off. So the idea of smart beta is to offset the impact of traditional market-cap – in other words, the concentration and the exposure to large-cap growth stocks, by investing in factors which have a better risk and return history.
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