Smart-beta flows have been growing and are drawing industry attention. At one extreme, practitioners profess that smart-beta strategies could disrupt the investment management industry. On the other extreme, early adopters have cautioned against chasing performance and highlight how some of these strategies can “go horribly wrong.” How has smart beta evolved, and are these claims realistic?
Information Overload
Making investment decisions has never been easy, especially in an increasingly data-driven world that has grown rapidly in complexity, size, and speed. The number of listed stocks in the world has doubled over the last two decades or so, and market capitalization has increased by nearly five times. This expansion has resulted in a number of operational changes for investment decision makers. One of the (perhaps) most unwelcome changes is the increase in the investors’ collective burden of due diligence. Everyone in the investment chain, not just stock pickers and asset allocators, is required to deal with a rapidly expanding information base.
Embracing Rule-Based Investing
On a related note — or maybe as a consequence — newer, simpler, program-driven decision-making tools have gained in popularity. Stephen Ross’s 1976 arbitrage pricing model, the Fama–French three-factor model, and other value tilting techniques have all contributed to the ideological base for quantitative strategies. In particular, fundamental indexing, introduced in 2005, quickly gained traction as an alternative for investors who were broadly divided into active and passive investing worlds. These rule-based approaches brought investing focus to quantitative factors beyond simple capitalization weighting and helped create a growing marketplace. Modeling fundamental measures of economic size — dividends, cash flow, book value — became a transparent and intuitive alternative for specific areas in the active space. For example, in the current low-interest-rate, zero-bound environment, it is easier to understand the massive popularity of dividend ETFs.
Smart Beta — Dumb Alpha?
It is too early to say whether smart beta can deliver disruptive innovation to the investment world. But, similar to the gradual but significant change that pure indexing has brought to active investing, smart beta, too, appears to be chipping away at parts of the active management product space. At the very least, the trend in investment flows suggests the risk is real that these products could significantly alter the active investment product market.
Delivering pure alpha from active management requires deep research capabilities and insights that can be costly. The fee differential may become significant given the machine/computer-driven approach involved in smart-beta strategies. According to Morningstar, smart-beta exchange-traded funds (ETFs) are significantly cheaper to own than active funds, but these ETFs are three times as expensive as their cap-weighted counterparts. (For reference, passive fees are in the range of 14 bps, smart-beta ETFs cost about 40 bps, and active strategies cost about 80 bps.) In an increasingly competitive world, higher fees can only face downward pressure, and the real cost of finding superior active management in an informationally complex world can only go higher.
Active managers charging relatively low fees but delivering superior returns will always be a class apart. The strategies that some of the active managers follow can also be difficult to replicate as a smart-beta equivalent. On the other hand, active managers delivering returns on simpler, rule-based smart-beta-like strategies (high dividend yield stocks, high return on equity stocks, etc.) but charging higher active management fees may face the most disruption and risk. Likewise, smart-beta managers, who have been delivering simpler smart-beta exposures but are charging active management fees, will be pressured to lower their fee structure.
Who Is Smart? Not the Betas
Another important difference: though an investor can exit out of an active-management strategy that underperforms, firing a smart-beta manager who delivers the promised risk exposures may be uncalled for if these exposures result in underperformance for the investor. The investor, in choosing the right risk exposure, may need expertise and knowledge to make a decision on the right smart-beta strategy. The investor is expected to be smart — not the beta.
Smart-beta investing has its advantages and risks. Understanding fee structures, product mixes of pure alpha-versus-beta strategies, and being able to distinguish these from pure passive indexing are important knowledge areas for investors to embrace in the investment decision-making process.