Strategies grow in size and complexity

But will smart beta steal a march on active fund management, or will its complexity be its undoing?

Smart beta generally moves away from market cap-weighted indices and into factor-weighted indices – the factors may be high dividends, volatility or value/growth metrics.

Recent launches include the S&P Global 1200 Dividend Stability Low Volatility index, designed to track companies that score highly for dividend yield and growth, as well as low volatility.

Cap-weighted indices generally work poorly for fixed income, skewing any investments to the most indebted countries or firms, and so passive fixed income products have struggled to gain traction.

Smart beta fixed income offers a potential solution. For example, Lombard Odier and ETF Securities are launching a series of weighted fixed income exchange-traded funds. These are weighted according to fundamental factors for government and corporate issuers, and are designed to identify issuers with the best ability to repay. This might be GDP or debt-to-GDP for governments, while for corporate issuers it will include revenues or indebtedness.

The smart beta market is set to grow in size and complexity. In its report ‘The future of fund management’, investment bank Nomura says that while the smart beta market is dominated by minimum variance or fundamental indexation/value strategies, it expects to see more sophisticated strategies emerge, including long-short or mixed-asset class.

Lombard Odier head of marketing and business services Ben Horsell says: “Smart beta allows investors to allocate to different areas – value, growth, lower volatility – on a modular basis, but people are looking at how these factors might be put together and combined.”

Smart beta is finding some support internationally. US services firm Towers Watson reports that its global institutional investment clients allocated more than $8bn (£5.1bn) to smart beta strategies during 2014. They now have total exposure of around $40bn across a range of asset classes. This compares with a $32bn exposure to smart beta strategies at the end of 2013 and $20bn in 2012.

But smart beta has yet to find a significant market in the UK, and there have been concerns over the complexity of some of the products launched. Fund selectors have struggled to see the value in a product where fees are, in some cases, almost as high as for an active fund.

HSBC head of passive equity Joseph Molloy says that where smart beta has been adopted, it has not usually been at the expense of active funds.

He explains: “We have found that people use them to shape a portfolio slightly differently. They may use them tactically and strategically for risk reduction, to get access to higher-dividend stocks, or to focus on value or fundamentals.”

Mr Molloy points out that turnover in smart beta indices is two to three times higher than for market cap-weighted indices, which gives them the headwinds of higher costs. That said, these fees are not as high as traditional active funds and the products offer similar diversification benefits.

Complexity remains a key concern. Luba Nikulina, global head of manager research at Towers Watson, says: “We believe smart betas should be easy to describe and understand, which many of these labelled products are not as often they are poorly implemented and seem naïve about the inherent risks. While growth has been phenomenal in the past five years, we expect to see continuing demand.”

Mr Molloy agrees some products have become too complex and investors need to understand what they are getting.

Equally, Mr Horsell says: “We are careful not to over-engineer [products] such that investors don’t know how to fit them into a portfolio.”

He thinks there will be a limit to the growth of the industry. “These products can’t be too sophisticated for people to understand how they work,” he says.

“It is still a rules-based approach, and this is more economical than appointing an active manager.”

Smart beta has its place in a portfolio, but is not being used as a replacement for active, but to draw out specific factors – to raise the income on a portfolio, or to give it a value or growth skew.

Complexity may be an issue, but the smart beta industry is aware of the problem. As the wider passive market gains ground, investors may slowly come round to the idea.

Cherry Reynard is a freelance journalist

Shift to passive products: Study findings

A study by the Boston Consulting Group, called ‘Global asset management 2015: Sparking growth with go-to-market excellence’, finds that the passive products market is set to grow further:

“The product shift of recent years – from traditional, actively managed products to passives, solutions and specialties – held true in 2014, although the move towards specialties has slowed.

“The assets under management (AUM) of active products represented 39 per cent of AUM at the end of 2014 compared with 59 per cent in 2003, while alternatives grew from 6 to 11 per cent, passive products from 8 to 14 per cent, solutions from 6 to 13 per cent and specialties from 21 to 24 per cent.

“This ongoing shift reflects investors’ persistent hunt for more outcome-oriented products, greater portfolio diversification and less-expensive products in core categories.

“We continue to believe that the structural shift from active core products to solutions, alternatives, passive products and specialties will continue. In particular, solutions and passives are likely to get a disproportionate share of the net flows relative to their current size. Therefore, they will remain the fastest-growing categories, squeezing the share of active core products and managers as those products suffer net outflows.”