A happy middle?
Written by Nadine Wojakovski
Nadine Wojakovski looks at smart beta and compares it to active and passive investing
The onset of the global financial crisis and the stress it placed on markets revealed the flaws inherent in market capitalisation weighted indices. It subsequently raised investors’ risk awareness and made them seek out more innovative ways of investing in indices.
The answer has come in the shape of ‘active indexing’ or ‘smart beta’, which aims to provide a cheaper, low-risk way of harvesting beta returns. Whereas the alpha/beta separation was previously black and white, with the onset of active index investment this is no longer the case.
Traditionally passive indices were assumed to be low-risk options. But they are much riskier than they look, argues Barnett Waddingham invest-ment partner David Clare. “They are only low risk if the performance of the index is right for the portfolio,” he notes. “I think passive management is far more risky than it appears from an initial glance of a low-cost way of matching the index. The real risk is making sure the benchmark you decided to choose is the right one for your needs.”
Clare says if you are matching liabilities, then with a passive index, as bonds get closer to maturity, they will fall out the index and probably be replaced by others such that the duration remains the same. However, the duration of your liabilities for a closed scheme will slowly start to decline, so you have a drift between your assets and your liabilities. There is also a self-fulfilling flaw in market-cap-type indices. As a company gets more successful they become a greater part of the index. The concern is that market-weighted indices create bubbles and/or the opposite if they get sold off. The other issue is that there are many thousands of indices with many variations of the same, be it emerging markets or a multicountry/asset-type index. The choice can be mind boggling.
In Clare’s opinion benchmarking against an index has possibly caused more problems than it has solved as it “significantly restricts behaviour”. He encourages trustees, where possible, to allow their managers wider discretion to take a view of the broader universe and not use the index as an excuse for underperformance.
In the last decade the market has seen the introduction of liability driven investment (hedging against interest and inflation-rate risk), and diversified growth funds (multi-asset-class investing and delivering equity-type returns but much more smoothly). With that backdrop the trend for smart beta is squeezing into the DGF and LDI space.
Northern Trust Global Investors has $400 billion in index strategies. Its combination of active and passive experience allows it to assess the indices and also build custom portfolio solutions for investors. Traditional market cap indices are still being used but alternative indices are now getting a lot of attention because of the control it gives back to the asset owner, observes the firm’s MD for EMEA John Krieg.
“New indices are trying to move away from market capitalisation or price being the determining factor in the index structure. Now they are weighted by some fundamental factor – such as profitability or another valuation metric or equally weighted for example,” he says.
Return seeking, risk mitigating and diversification are popular characteristics within these new alternative indices. Other popular ones are low volatility, dividend seeking and maximum diversification.
Active index investment is about applying some principles of passive management in a smarter way. Barnett Waddingham’s Clare says that passive management is a numbers game that strives to understand how the index changes and how best you can monitor that with least cost. It is technically far harder than it appears. “What you remove from the equation is whether stock A is better than stock B as what you care about is the weighting within the index,” he explains.
By contrast, active indexing is applying an element of judgement as well as the statistician’s view. It is not purely active because it is still very much index driven. So the investment manager is taking an active view but relative to what the index is doing. “We are effectively trying to deliver index performance, in a smarter way so decision making is not purely mathematical,” he adds. His favoured area for active index management is within the corporate bond market as it is taking advantage of a fundamental change in the corporate bond market.
Pre-2008 it would not have been attractive as corporate bond markets were far more liquid but it is very appropriate now.
“There has been a rise in invest-ment activities associated with beta as investors seek to generate market-like returns cheaply and efficiently,” says AXA Rosenberg Europe CIO Gideon Smith. This can be achieved through a broadly diversified portfolio designed to capture beta in a more efficient way, either with respect to the price paid, reducing the overall risk or enhancing it in some other way.
One of the features of cap-weighted benchmarks is that as stocks become larger they naturally increase their weighting, so by design you end up investing in more expensive companies that can be concentrated in just a handful of stocks. Through the fund manager’s analysis of market returns and the fundamentals of the stocks that drive those returns, the investment manager has been able to identify uncompensated risks in the market, such as risks of distress, liquidity and concentration. For over five years it has been building risk efficient beta portfolios – reweighting the market index in order to reduce the portfolio’s exposure to uncompensated risk.
“Smart beta is our approach to reducing exposure to those uncompensated risks in order to create a portfolio that is less volatile than the indices,” explains Smith. He believes this can be attractive for pension funds investing in equities – as if a scheme is doing asset liability matching it allows it to invest more in equities than it would normally do.
Says Smith: “We focus on a reduction in volatility, a reduction in speculative growth and focus on more stable earnings. We also avoid tail risks such as risk of distress – stocks that may look cheap but are cheap for a reason. We identify these systematically and reduce our exposure to them.”
But Vanguard CIO Europe Jeff Molitor says the term smart beta is misleading. It implies that if it is ‘smart’ it must be better. He argues that smart beta represents just “a slice in the market” rather than the whole market. “The approaches are quantitative efforts to de-emphasise some issues and emphasise others through active management.” This, he says, amounts to taking active bets. “What we have seen again and again is that active bets will work at some times but will not necessarily be enduring. Investors going into smart beta have to realise they are taking a bet that may or may not work. They are not perpetual added value machines.”
Molitor opines that people attempting to time smart beta strategies are fooling themselves. “Do you know which preferences will be rewarded at which point in time as different strategies and approaches go in and out of favour? Too many investors select on a momentum basis. Looking at things on a historical basis and assuming they all extend on does not work.”
Instead, in his view, the starting position has to be the opportunity set which is the market. So if someone is looking at equities then a global equity index is a very good starting point rather than the customised option of active index investment.
Nonetheless, in spite of his and other critics’ opinions, the growing interest in smart beta or active index management has resulted in index providers – such as MSCI, Russell, FTSE – developing a plethora of new index strategies to meet growing demand. It could be a customised index strategy where a client wants to exclude certain countries or sectors or it could be tilted towards certain risk factors. Or it could be a combination of passive and active. This is where there is a lot of active involvement in the design of the index and then it is passively managed. It might, for example, have a tilt towards quality or value but still have similar characteristics as the underlying market cap index.
Northern Trust Asset Management senior product specialist of EMEA &APAC Mamadou-Abou Sarr says there is room for both alternative indices and pure active strategies in asset owners’ portfolios. Indeed, the surge of alternative indices offers more tools for investors to target specific factors.
He says: “The alpha/beta separa-tion is not clear cut anymore. Investors are revisiting their active strategies with more scrutiny to understand their true beta exposures and assess whether or not it would make sense to replace or complement the active portfolios with smart beta strategies.”
Written by Nadine Wojakovski, a freelance journalist