Is ‘smart beta’ the latest magic money tree? Returns could decline as more money flows into the strategies

April 14, 2014 8:30 am

Is ‘smart beta’ the latest magic money tree?

By Pauline Skypala

Returns could decline as more money flows into the strategies

Investors are always on the lookout for a magic money tree. The latest candidate for that label has been dubbed “smart beta”, although some would argue it fits neither of those descriptions.

Even conservative investors such as Japan’s Government Pension Investment Fund, the biggest pension fund in the world, have embraced this trend. The fund announced this month it would be moving some of the money in actively managed equity strategies into smart beta instead.

The approach is sometimes described as a halfway house between traditional active management, where fund managers pick stocks they think will outperform, and the passive variety, where a fund replicates the returns of an index.

So what is it? Unhelpfully, there is no standard definition. It is more of a marketing label than a useful investment description. The name suggests a passive strategy with a clever twist, as beta is the term used to denote market risk.

The typical twist is to substitute the standard market capitalisation weighting of an equity index with an alternative weighting, such as dividends or earnings. This is claimed as a smarter approach as market cap indices will inevitably be overweight on expensive stocks and underweight on cheap ones.

Tilting an index towards a risk factor expected to provide a premium, such as value stocks or small-cap stocks, is another regular twist. It is arguably what the alternative weighting approach effectively achieves.

These are not new ideas but they have gained traction among investors because they search for anything that might squeeze extra return from their assets.

Amin Rajan, chief executive of Create Research, a fund consultancy, says some of the earliest adopters of such strategies were institutional investors in the Netherlands and Denmark, which reported good results.

As more money flows into such strategies, though, the premiums they offer could shrink. Pioneers may have gained an early mover advantage that will not be available to the crowd, says Mr Rajan.

But he contends the true source of returns from smart beta strategies is not the risk factors they tilt to but the rebalancing they force.

If investors plan to embrace smart beta they need to understand what factors are driving the returns, what risks they are taking and whether the strategies offer value for money

Rob Arnott, chairman and chief executive of Research Affiliates, which has $166bn under management in smart beta strategies, agrees with that assessment. He is on record as saying the value tilt of his company’s products accounts for about a third of the added value he claims for them, with the rest coming from the rebalancing. Or, as he puts it, from “the dynamic contra trading against the market”, whereby “we trim whatever is most newly beloved and use the proceeds to top up whatever is newly feared and loathed”.

The question is whether smart beta will prove to offer a better outcome for the risk involved than cheaper passive products, or more consistent outperformance than higher cost active management. Is there a free lunch on offer here? There is no answer as yet, says Mr Rajan.

Critics such as James Montier of GMO, an active fund manager, maintain that when smart beta strategies are adjusted for their exposure to small-cap and value stocks, they do not show any significant outperformance of cap-weighted benchmarks.

Academics continue to debate why investors can collect a risk premium by focusing on value stocks or small-caps, portfolio tilts widely recognised as offering a long-term premium. Behavioural finance experts put it down to mispricing, while those who adhere to the tenets of the capital asset pricing model view it as a sensible relationship between risk and return.

The annual examination of investment returns by Elroy Dimson, Paul Marsh and Mike Staunton, sponsored by Credit Suisse, shows both premiums can be significant, but can also disappear for periods, as both did in the 1990s. The small-cap premium has also declined since it was first remarked on in the early 1980s and over the long run, according to the Credit Suisse Sourcebook, investors in small-caps should expect no more than a normal reward for the risk they are taking.

The value premium, especially the high-yield subset, has been quite large historically and “to many researchers” appears to outweigh the additional risks of holding lowly valued companies, say the three Sourcebook authors.

However, the biggest premium has come from the momentum effect, which can be captured by buying winning stocks and selling losing ones. Investors trying this can suffer whipsaw from sharp reversals, though, and it is not a widespread smart beta offering as yet.

If investors plan to embrace smart beta they need to understand what factors are driving the returns, what risks they are taking and whether the strategies offer value for money. They must also be prepared for disappointment if the historical premiums slim down with higher flows. Smart beta could turn out to be plain beta, at a higher price. There is no magic money tree.