Fund management: The rise of smart beta

Fund management: The rise of smart beta

Terrible name, interesting trend

Jul 6th 2013 |From the print edition

INVESTORS face a quandary. Cash offers a return of virtually zero in many developed countries; government-bond yields may have risen in recent weeks but they are still unattractive. Equities have suffered two big bear markets since 2000 and are wobbling again. It is hardly surprising that pension funds, insurers and endowments are searching for new sources of return. Step forward “smart beta”, the latest bit of jargon from the fund-management industry. “Alpha” is the skill required to choose individual assets that will outperform the market; “beta” is the return achieved from exposure to the overall market, for example via an index fund. “Smart beta” is an approach that tries to enhance the return from tracking an asset class by deviating from the traditional “cap-weighted” approach, in which investors simply buy shares or bonds in proportion to their market value. The sector is still small: there is just $142 billion in smart-beta funds, compared with more than $2 trillion stashed in hedge funds. But the concept is catching on. According to State Street Global Advisors, smart-beta funds received inflows of $15 billion in the first quarter of 2013, up by 45% on the same period a year earlier.Such enthusiasm is another sign that the quants are taking over. Traditional fund managers were able to charge a fee for their alleged skill and judgment. The quants are showing that when such managers did outperform, the excess return was driven by factors that can be identified and commoditised. Fees for smart-beta funds tend to be higher than those charged by cap-weighted index funds but far lower than those charged by other managers.

There is a variety of smart-beta approaches. The simplest is to give each market constituent equal weight. If there are 100 stocks, then each would have a weighting of 1%. A second approach, dubbed “fundamental indexing”, is to weight each company by its financial characteristics—sales, dividends, assets or cashflow. A third is to weight the index in terms of the volatility of the stocks, with the least volatile being favoured. A fourth is to use the “momentum effect” to buy stocks that have recently risen in price. That’s just for starters.

A two-part study by academics at the Cass Business School found that all these alternative indices beat a cap-weighted index over the long run, and had a better risk-adjusted return. The study also found that a system that randomly chose constituent weights for stocks, like chimpanzees throwing darts at share-price listings, beat the market. As Jason Hsu of Research Affiliates, a firm that has pioneered fundamental indexing, says, these findings suggest big flaws in the cap-weighted approach.

Cap analysis

When a company’s share price rises faster than the rest of the market, this means that it has a bigger weight in a traditional index. When its share price falls, its weight reduces. A strategy that attempts to match the cap-weighted index is thus buying high and selling low; put another way, it has a big exposure to the most expensive stocks. That makes it easier for alternative indices to outperform over the long run.

The low-volatility approach exploits a similar anomaly. In theory, the riskier the asset, the higher the potential return for investors. In practice, however, low-volatility shares have performed much better than theory would suggest. According to Churchill Franklin of Acadian, a fund-management group, a dollar invested in the least volatile American shares (by quintile) in January 1968 was worth $59.55 by December 2008; in the most-volatile quintile, $1 fell to 58 cents.

This may reflect the fact that fund managers get rewarded for picking stocks that beat the market. So they opt for volatile stocks that appear to offer high returns, which makes less volatile stocks relatively cheap. Managers could just buy the less volatile stocks and lever up the return with borrowed money; regulations and client wishes usually prevent that.

Not everyone is convinced about the low-volatility approach. “Very few things are a free lunch,” says Glyn Jones of P-Solve, an investment consultancy. “If you push down on one risk, it pops up elsewhere.” A low-volatility strategy might result in a heavy exposure to utility stocks, and to the risk that governments will change the rules that govern their profits.

This problem of “style bias” can make smart-beta investing riskier than it appears. The equal-weighting approach takes advantage of the fact that small stocks tend to outperform large ones. Fundamental indexing depends on the tendency of so-called “value” stocks to beat those favoured because of rapid profits growth. But the shares of smaller companies are often illiquid, and so it can be expensive for a fund manager to buy a big stake. The kind of stocks that fall into the value category may be risky: there is a reason they look cheap, after all.

Another problem is that rebalancing a smart-beta portfolio may involve transaction costs that are higher than for a cap-weighted index fund. The latter does not have to do anything to its portfolio as prices move; an equal-weighting fund, by contrast, has to readjust its holdings. These extra costs will weigh on performance.

Smart-beta enthusiasts think these problems can be solved. To tackle style bias, EDHEC, a French business school, offers what it inevitably calls “smart beta 2.0”—over 2,000 indices that allow investors to, for example, diversify exposure to one industry. Mr Hsu says that fundamental indices need rebalancing once a year, meaning that only around 12% of the portfolio will get turned over. Conventional fund managers often turn over their entire portfolio in a year.

If enough money flows into these smart-beta products, then they will start to look more like cap-weighted indices that replicate the holdings of the average investor. As Mr Jones of P-Solve says: “There are things that individual pension schemes can do to beat the average scheme, but all of these ideas are tiny compared with the amount of capital seeking an extra return.” For now the industry is set to grow. If you are a pension trustee, get used to the jargon.