InvestmentsMay 16 2016

Helping to bridge active-passive gap

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Helping to bridge active-passive gap

The term ‘smart beta’ often raises questions among investors – the most common generally being, ‘what is it?’

It is an important question as different providers have different definitions, investors need to know what it is they’re investing in, and smart beta strategies differ from other passive strategies that simply track an index like the FTSE 100.

Simon Midgen, head of index strategy at Legal & General Investment Management (LGIM), admits the term has stuck even though it is “somewhat confusing”.

“Confusing because it suggests regular index management might be dumb beta, which is certainly not the case,” he says.

“Smart beta is probably anything that is not market-cap driven, so anything other than a strategy that is benchmarked against a standard market index, the FTSE All-Share, for example. Standard market indices are built where the calculation of the index gives more weight to bigger companies and less weight to smaller companies in proportion to their size – pretty straightforward.

“Smart beta is anything that deviates from that, so has a different calculation methodology or weighting approach.”

The rise of smart beta

Howie Li, head of Canvas at ETF Securities, comments on where smart beta strategies sit within an investor’s portfolio:

“What we’re seeing in the market are lower cost products for investors, which can only be a good thing. Smart beta gives investors the ability to generate something on top of market cap returns but it requires an understanding of how these tools should be used.

“There will always be active managers that can deliver additional returns but investors must do their due diligence and check that the investment process can deliver and has delivered value so that the additional fees are justified. Market-cap investing also has a place if investors simply want market exposure.

“Therefore, the merits of an active, passive or smart beta strategy within a specific portfolio must be carefully weighted by advisers with clear grounds for choosing one over another. It is likely that a portfolio will have a blend of each, and each strategy will continue to have a place in an intelligently diversified portfolio that delivers their clients the best value.”

Chris Mellor, executive director, equities product management at Source, offers a similar explanation: “There is a lot of divergent opinion. Our definition is pretty broad, it’s basically anything that deviates from a simple market cap weighted benchmark and does so in a systematic, rather than a discretionary, way.”

In the past, smart beta strategies have been more commonly used by institutional investors but passive providers are increasingly bringing to market smart beta products aimed at retail investors.

Mr Midgen observes he has seen a significant amount of assets flow into smart beta strategies, although this is still dwarfed by the assets held in traditional index-tracking funds. By December 31 2015, LGIM had £25bn in smart beta strategies and £298bn in index strategies.

Smart beta can be a misleading title in that it can suggest an investment might get all the benefits of beta Neil Cowell

Smart beta’s selling point seems to be that it sits somewhere between active and passive funds.

Mr Midgen explains: “Smart beta is a bit of a halfway house between pure passive, where the objective is to reflect the broad market returns, and pure active where, through stock selection or market timing or research, a manager identifies investment opportunities. Smart beta sits in the middle.

“For example, one of the drivers of the growth of value smart beta strategies is investors thinking, ‘if I believe in value as a systematic source of return, I can pay an active manager, or I could implement my strategy through a rules-based approach that may capture what the active manager may achieve for me anyway, but at a lower cost’.”

Howie Li, head of Canvas at ETF Securities, agrees smart beta products are seen as a “bridge” between passive and active investing.

But, he cautions: “Like an active fund, smart beta products are designed to add value. However, while it empowers the investor to seek something in addition to market exposure – beta – at a lower cost, it is important for investors to understand which tools should be used to match their desired investment outcome.

Definition of smart beta

In a report published by Source in November 2015 called ‘Being smarter about “smart beta”’, author Chris Mellor, head of equity product management, asks what’s in a name?

The term “smart beta” is now widely used but is not universally accepted. There are many other terms that refer to roughly the same category of investment products, including strategic beta, non-traditional indices, advanced beta, enhanced beta, beta plus, engineered beta, and second generation indices.

How other providers and firms define smart beta:

• Between alpha and beta (Towers Watson)

• The middle of the passive-to-active spectrum (Morningstar)

• Investment strategies based on one or more of the five equity factors (SSgA)

• Indices that are not weighted by market capitalisation (Russell Investments)

Source: Being smarter about ‘smart beta’, by Source

“There is no ‘one size fits all’ product and the purpose for each smart beta product can vary greatly from minimising volatility of a passive investment, to tracking momentum or improving risk-adjusted returns. With the proliferation of smart beta products coming to market, an understanding of their uses, as well as timing, is paramount.”

If an investor is comfortable with how smart beta works then there are an array of products offering exposure to different factors, whether that’s value investing, momentum or small-cap stocks.

Smart beta also highlights some of the limitations of passive or index funds, as Mr Mellor acknowledges. “The best example of that is the tech sector, which made up more than a quarter of the S&P 500 [index] in 1999 and we all know how well an investment in the tech sector went in 2000-02 as the bubble burst.

“So building strategies in a systematic fashion that avoid some of those biases or give you exposure to low volatility or the long-term factors… will give you better performance than a standard market cap weighted benchmark and better performance than an active strategy as well.”

Not everyone is convinced, though, and passive provider Vanguard is careful to avoid the term smart beta. Neil Cowell, head of UK retail sales at Vanguard, remarks: “Smart beta can be a misleading title in that it can suggest an investment might get all the benefits of beta, with some additional benefit on top. We call it rules-based active, and if you are making a decision away from market cap weighting, just be very clear about why you’re doing it and what you expect to get.”

Ellie Duncan is deputy features editor at Investment Adviser