Strategic beta, more commonly known as ‘smart beta’, is all the rage at present.
Everyone in the exchange-traded fund (ETF) world talks about it and new products carrying the label launch almost every week.
Investors are buying into the concept, too. Designed to either improve returns or alter risk relative to traditional market cap-weighted indices by using factor tilts, strategic beta indices are garnering assets. Global assets in strategic beta ETFs have grown by 87 per cent in two years and now account for $380bn (£239.6bn), according to Morningstar data.
Some see the rising popularity of these ETFs as a competitive threat to traditional index investing. They argue that market cap-weighted indices are inherently flawed and believe that, as passive investors become progressively acceptant of this fact, they will seek smarter ways of building portfolios, based on systematic risk factors.
I disagree. In my view, investors wishing to be exposed to the broad market will continue to favour cap-weighted indices, as these will always be the best representation of the market. Rather, I believe strategic beta ETFs could pose a serious threat to active managers, especially those who charge high fees for little added value, or alpha.
Traditionally, portfolio returns have been broken down into beta and alpha. Beta is the return of the broad market, while alpha – which one hopes is positive – is what’s left over; unexplained and often interpreted as evidence of the manager’s skill.
Over the past decade or so, investors’ perception of what alpha truly represents has evolved. Many have come to the realisation that a portion of what is considered alpha can easily be explained by market factors, thus leaving a smaller-than-thought portion of a portfolio return attributable to active management, such as picking securities.
If this is so, then why not cut out the middle man and own the factors directly?
This is a question some large institutional investors have begun asking themselves.
The Government Pension Fund of Norway – the largest pension fund in Europe – and Calpers – the biggest public pension fund in the US – have both embraced the passive, risk-factor-based view of the world. Individual investors and advisers need to consider whether they should, too.
I believe active fund managers who mostly load up on factors don’t deserve to charge high fees. There are now plenty of low-cost, transparent and formulaic factor-mimicking funds – predominantly ETFs – to choose from, with more coming down the pipeline.
For traditional active fund managers, the implications of the evolution of index investing and, in particular, the rise in popularity of strategic beta ETFs are twofold.
First, they have clearly raised the bar. Indeed, a truly skilled manager will now have to demonstrate that he or she can outperform after deducting the influence of easily measurable factor exposures.
Many studies show that once this deduction is made, evidence of a manager’s skill becomes really hard to detect.
Second, if the active manager’s returns are mostly the result of a combination of passive factor tilts, then there is little justification for commanding high fees.
With that in mind, active managers are set to face ever-increasing pressures to demonstrate their merit.
Hortense Bioy is director of passive fund research, Europe, at Morningstar
