Measuring the benefits of Smart Beta

Alternative indices might not serve well as easy-to-use investment products, but they may improve the measurement of fund managers and offer diversification benefits.

It has apparently never been that easy to be smart. A flood of Smart Beta products have come onto the market in the past couple of quarters, with fund management groups capitalising on growing demand for alternative indexing.

According to data from IndexUniverse, investors pushed more than €38bn into US “Smart Beta” ETFs since the start of this year, with asset management  groups and banks like HSBC and Deutsche Bank recently jumping on the bandwagon of creating alternative indices.

Index providers such as S&P Dow Jones indices talk about “unparalleled requests” to customise benchmarks and indices for institutional clients, when quizzed by InvestmentEurope, from fixed income to equities. Taiilwinds for the still-small asset class come from academics.

A recent two-part study by Cass Business School professor Andrew Clare revealed the short-comings of cap-weighted indices, claiming that even monkeys could produce better ways to allocate capital. Thus, especially alternative weightings to equity markets, such as valuebased or risk-based methods have gained popularity. Reactions among professional investors are, however, not straightforward.

“Smart Beta is not a proper wording. The beta is not smart, but alternative.” That is the conviction of Sven Thießen (pictured), head of Quantitative Equity Strategies at German fund manager Deka. He adds that there is more to the discussion than just a marketing buzzword: “The growing interest in alternative beta strategies is important, because investors start to think more in terms of risk factors than just asset classes.”

Indeed, the main work for quantitative managers such as Thießen is to work with dynamics: “The dynamics of the relationship between risk factors and returns is the core.” The fundamental approach to equity portfolios therefore still remains to combine value factors with other well tested variables to build portfolios.

According to Max Holzer , managing director and head of Asset Allocation at German fund management group Union Investment, “Smart Beta is not all about
old wine in new bottles”.

For Holzer, the renewed interest in breaking up alpha into various strategy betas and true management alpha is an important tool for fund selection. “Professional fund analysts today can look very closely whether a fund manager’s performance has strategy elements to it. In effect, the skill of a manager can be measured quite precisely.”

Holzer and his team are looking for strategies that exhibit “a certain systematic anatomy”, like value and/or the small cap premium. Beyond those traditional betas, popularised by the research of this year’s Nobel Laureate Eugene Fama , among others, anomalies and strategies can be divided into Smart Beta and pure alpha.

“We have found that there are a number of investment strategies that offer attractive premiums or reduce risk in a portfolio, at least for the long term”, Holzer says.

That includes low volatility in the equity space. This strategy aims to invest in equities with lower risks, measured by volatility or variance, as these safer assets have proven to outperform higher beta equities on a risk adjusted basis – “a well-established fact”, as one selector notes.

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