Sustained growth puts smart beta under the microscope

Selectors are increasingly being asked to consider the merits of ‘smart beta’ on behalf of their clients, but opinion on its role in providing superior risk adjusted returns is not clear cut.

With markets about to head into a period whereby a raft of data will suggest they have done nothing but gain over half a decade, the ability to spot beta contribution to portfolio performance and find ways to ensure returns are maintained against reasonable levels of risk is likely to become increasingly important.

Smart beta strategies have been growing both in number and by assets gathered, as noted by, for example, Tim Gardener, global head of Consultant Relations at AXA IM – one of the providers of such strategies.

He argues that with investors becoming increasingly aware of return lost by tracking market capitalisation indices, they are looking for alternative strategies that avoid this problem. And with demand continuing, the industry has already moved to a second generation of smart beta (SB) offerings in both equity and fixed income, he notes. “Beta harvesting typically generates over 80% of return.

In consequence more and more investors are looking to this kind of solution to act as the base or core of their portfolio, perhaps then using alpha strategies to generate excess returns on top.”

However, Gardener’s explanation also illustrates why this is a challenging area for the industry in terms of finding common descriptions of what this type of strategy is actually seeking to accomplish.

“Beta strategies have to be understandable, low cost – in terms of management and transaction costs – transparent – to allow us to communicate clearly how the strategy is positioned at any time, and lastly systematic – returns that come from exploiting long run market anomalies rather than taking risk positions to exploit inefficiencies.”

“We do draw a distinction between ‘alternative beta’ which we regard as a useful categorisation of all indices which are not market capitalisation. However to us ‘smart beta’ is about alternative beta strategies which are, in addition, ‘smart’.

“We think to be ‘smart’ you avoid unnecessary risk and costs and focus on the outcome the investor wants rather than on devising different index constructions. Some alternative betas are smart and some are less so. Traditional market capweighted indices are certainly not smart in that they expose investors to sources of structural systematic risk that, over an investment cycle, are under-compensated.”

Still, despite the apparent nuances, from AXA IM’s perspective, the growth in AUM in the relevant strategies suggests it “is not a passing fad, but rather a global trend that is here to stay.”

“The AUM figures for both our credit and equity strategies thus far are encouraging, given their relative youth. The fixed income strategy has €1.3bn in AUM and equity is over €2bn. This type of growth has not gone unnoticed by those offering other ways of investing in beta. For example, Jeff Molitor, CIO Europe at Vanguard, commented last year that SB strategies in some regards
are a new take on sector rotation strategies used by investor in previous times, and that there are still risks as with any type of strategy, such as the propensity to lead or lag behind other types of strategies at different times.

Investors in different markets may also be more or less interested, according to a comment from Emanuele Bellingeri, head of Italy for iShares, the ETF platform of BlackRock.

“Smart beta strategies have seen a huge rise abroad, less so in Italy. As per iShares’ ETFs, we are now concentrating more on placing our products with traditional strategies.”

Xiaowei Kang, senior director Research at S&P Dow Jones Indices, suggests investor demand is being pushed by those seeking alternatives to both passive and active portfolios.

Those seeking alternatives to more traditional active portfolios are estimated to account for two-thirds of the demand for this type of strategy among institutional investors.

The reasons for these searches are fairly clear, he suggests. Those replacing passive portfolios with SB are doing so based on discussion and theories around mispricing and asset prices, and are effectively seeking more efficient portfolios.

Those replacing actively managed portfolios are doing so because the active management has produced disappointing performance.

The change is also based on growing recognition that long term risk premia account for the majority of portfolio returns. Thus, instead of paying expensive fees to active managers, it is possible to restructure portfolios to access return via SB at lower cost.

In terms of the supply side, Kang notes that SB providers come from both camps – active and passive managers. S&P DJI sees this in its capacity as a researcher and provider of indices used to access non-market capitalisation weighted return.

The design of SB products is basically done to allow investors to build risk budgets in a certain way, Kang continues. This in turn leads to offerings in the market such as risk parity type strategies, and ones that control volatility. It comes back to the objective of ensuring better control over risk.

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