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Is smart beta really smart?

by Mike Abbott | Jun 07, 2016
  • Smart beta has become the latest fashion in fund management in the US and, more recently, in the UK and Europe. It’s a new, exciting and different concept. With the asset management industry under more pressure than it’s been for some time, this new fad is a most welcome boost to the marketing departments of the world’s top fund management houses.

    The source of the pressure being felt has much to do with mounting academic evidence that active stock picking fund managers are struggling to outperform market indices consistently over time. Downward pressure on forward-looking returns (due in part to quantitative easing in the developed world and the global savings glut) has placed downward pressure on prices in the investment chain.

    The margins asset managers are used to charging are now being squeezed by underperformance in both relative and absolute terms. It is in this context that providers of large scale index tracking products have seen a meteoric rise in the growth of their assets under management. However, more recently, there has been the arrival of the smart beta style of fund into this passive index tracking investment arena. Smart beta is a term that describes attempts to track markets by means other than the well-known market cap weighted indices.

    What’s the rationale for smart beta? Quite simply it is very difficult to build a globally diversified mixed asset class portfolio using only index trackers. This has something to do with the fact that any index is a representation of a segment of each market and not the market itself. Therefore, trackers provide limited and specific exposure to a market - not the best or most appropriate or most diversified exposure to that market.

    By removing the requirement to hold a specified market cap weighted index in its specific proportions, a smart beta fund can increase diversification, reduce trading costs and provide better investor outcomes. In the fixed income arena, indices are limited and restricted mainly to sovereign debt markets excluding corporate debt. A completely passive fixed income fund would currently be holding large exposure to bond markets with negative yields.

    A smart beta manager can ensure they only hold instruments with positive yields. Therein lies the rationale for smart beta, which is an attempt to improve on the portfolio design while containing the costs and avoiding the misplaced desire to “time” the markets.  

    What does smart beta do? This is where it can become complex. As you can imagine, the views on how best to actively intervene in the structure and holdings of what is essentially a passive portfolio varies dramatically among smart beta portfolio managers. Here at Sable Wealth, we have the view that most smart beta providers are not actually providing smart beta, but instead are providing tracker portfolios with a conglomeration of premiums (or factors) thrown in. 

    What is a premium (or factor)? A premium is a dimension of higher expected return. The market premium is the best known. We know which equities have tended to outperform bonds over time. We know this because the data shows strong statistical evidence that investing in equities has a probability of higher expected return than investing in bonds. However, the market premium increases risk. So we also know, historically, equities have more risk than bonds. Below is a graph showing you the market premium in the US market from 1928 – 2015.

    smart-beta one graph

    How many premiums are there? This is where smart beta providers differ. Our view at Sable is that a premium should only be included in our portfolios where it has strong academic evidence and support, and is tradable in the portfolios without contributing greatly to cost. The well evidenced premiums, in our view, are the market premium, the small cap premium, the value premium and the gross profit premium. Below is a graph that illustrates how these premiums have performed over time in the UK market between 1928 and 2015:

    smart-beta four graph

    The above illustration shows clearly that premiums introduce risk as they are not positive in each year and they tend to provide additional (compounded) return over time. To understand the effect over periods of time, it’s worth looking at how the premiums add return over longer periods. If we look at a five-year period for US data, then you get the following visual:smart-beta-rolling-periods

    How do you “access” a premium? It’s our view at Sable Wealth that accessing the premiums is actually the real art of smart beta investing. It’s for this reason that we dismiss many pretenders to the label of smart beta as anything but.

    The challenge facing index tracker funds is that they cannot execute the offered investment strategy efficiently. This is called the re-constitution effect. When a stock moves into our out of an index at a specified date, all tracker funds automatically trade against each other to purchase that new holding and all sell against each other to sell the existing holding. That situation produces the worst outcome for the investor, as your cost of acquisition goes up in a rising bid-offer spread. Real smart beta funds ensure that trading strategies align with the investors interests. 

    How do they do that? Firstly, by not buying stocks that display anomalies in their price behaviour - such as IPOs and stocks involved in mergers and acquisitions. Secondly, they avoid exchanges with low transparency and governance. Thirdly, they respect the principle of the trade triangle. That is: You cannot influence price, quantity and time simultaneously.

    Explained differently, if you know you want a specific quantity of a stock and you need it now (like an index tracker fund) then you can’t dictate your preferred price. Alternatively, if you are flexible on quantity and time of delivery, then you can have a significant influence on the price you pay. By not being wedded to a specific index, true smart beta providers can ensure their trading costs are kept low and their investors get the best possible price. 

    How do they put this all together? In short, with scale, skill and a large research function. We believe that smart beta is here to stay and will become a mainstream component of the investment arena in the coming decade. Smart beta is growing out of the synthesis of academia, technology development and the globalisation of finance. This convergence is allowing the best providers to synthesise the best research in finance and execute those findings through highly complex trading strategies executed globally at a low cost.

    The final point about cost is significant and is the reason I believe new entrants into smart beta will be limited and need to be regarded with some scepticism. Providing true smart beta is not easy to do at the price point that makes the premiums economically viable to the end investor.

    Our preferred smart beta provider has been providing these solutions and developing them since 1982 and has Nobel Prize winners in finance on the advisory board. This highly complex process delivers some really simple outcomes for the end investor - i.e. an evidenced-based investment solution that delivers better investment outcomes than a tracker fund, while avoiding the boom bust reality of active fund management. 

    If you have any wealth-related queries, you can contact an adviser at wealth team by calling us on: +44 207 759 7519. Alternatively, you can send us an email and we will get back to you.

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