Active versus passive
Axa IM global head of consultant relations Tim Gardener believes the industry needs new words to categorise investment strategies rather than just ‘passive’ and ‘active’. “We talk about ‘beta harvesting’,” he adds, “which is trying to squeeze the maximum amount of return out of a market without taking on undue levels of risk; and ‘alpha hunting’, which is deliberately taking risk for a return.”
Russell Investments’ Lace says: “I tend to draw the [passive] line at two points: one is whether it is rules-based – portfolio construction should be based on rules not judgement; and the other is transparency, but it should be future transparency so because it is rules-based you should know how it will respond to a certain market development.”
Hodnett says Parametric is “very much an active manager” of these strategies. “We take active decisions on the portfolio on the construction process in the ranking of the countries and we look to equal weight on a sector basis and make active decisions on the dynamic rebalancing process.”
Intech’s Schofield meanwhile, says: “It is alpha because it is an optimisation process that relies on our estimations of the stock volatilities and correlations and it is an optimised portfolio and it requires skill to do that – it is not a purely mechanistic thing.”
But where does this leave smart beta on the fees spectrum? According to Axa IM’s Gardener, fees have been “unjustifiably high” but are now coming down and fall anywhere between 40 basis points (bps) and 12bps. “Some people in this space were charging what I regard as ridiculous sums,” he says. “This should be a low-cost commodity product. We think eventually it will settle at 25bps or below, but it depends on the strategy. It is not a 40bps plus strategy – that is the territory of active managers.”
Down with market cap?
But does market cap still have a place in portfolios? S&P Dow Jones Indices’ global head of index strategy Craig Lazzara dislikes the term “smart beta” because it insinuates traditional cap-weighted indices are somehow “dumb” when in reality most active managers underperform cap-weighted indices most of the time.
The most recent S&P Indices Versus Active Funds (SPIVA) data shows most active managers in all categories except large-cap growth and real estate funds underperformed their respective benchmarks in 2012. Performance lagged behind the benchmark indices for 63.25% of large cap, 80.45% of mid cap and 66.5% of small cap funds.
Lazzara says: “The average active manager fairly consistently underperforms the capweighted index. Given that, using capweighted indices as a significant part of your portfolio is a very smart thing for most people to do. There is nothing dumb at all about cap-weighted.”
As Aon Hewitt senior partner John Belgrove observes, another key point is not just to have market cap at the core, but to also diversify exposure to smart beta strategies. “I would recommend that portfolio construction does not rely on one strategy,” he says, “i.e. diversify your strategies and have some alongside cap-weighted.”
Investment evolution
While strictly speaking the concept of smart beta seems to be nothing new, it is fair to say it is constantly evolving and has pushed the boundaries of alternative index investing. It can offer investors benchmark-beating returns without the active price tag, just as long as providers keep costs in check. It is likely investors will diversify their exposure across smart beta strategies while keeping market cap strategies at the core, but before committing should ask themselves whether they are interested in return, reducing volatility or a mixture of both.
As the PPF’s St Hill says: “It is inevitable as it becomes cheaper to produce solutions people will put new bells and whistles on them. What is likely to happen is an increased ability for asset allocators to hone in on specific smart beta exposures which match their liability profile.”
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