Smart beta: where is the value?

I’ve been contemplating the “smart beta” wave the industry seems to be riding at the moment. Cynically, part of that contemplation asks whether there is any innovation at play or whether it’s simply the industry playing with nomenclature once again.

The answer is confusing, for while I’d like to be able to write it off as some sort of marketing game, there seems to be some real benefit to the end-investor of this smart beta trend.

Whenever a journalist contemplates something, it means a lot of research and part of the way I research is by talking to people. On this issue I’ve sought the insight of many people close to the trend – academics, investors and service providers.

Of those service providers whose opinion I value, State Street and AQR rate up there.

It’s not my usual practice to name service providers, in fact I don’t really even like writing about them, but the reason I rate them, and this is not exclusive, is they have a direct link with academia, applying the latest thinking to practice. And this is true of the thinking around smart beta.

If flows are anything to go by then this so-called wave is real.

The S&P Low Volatility ETF had flows of $2.5 billion in 12 months and now has the most assets under management of any ETF.

Similarly, the trend is demonstrated in State Street Global Advisors’ flows, while the bulk of it’s $1 trillion in global passive equity remains in traditional core cap-weighted indices, last year 40 per cent of its institutional inflows in this part of the business were into smart beta.

Smart beta defined

The definition of smart beta can be broad. Lynn Blake, global chief investment officer of SSGA’s global passive equities business, says it is an “objective, consistent, transparent measure of achieving some investment exposure”. In academia, smart beta really started about 10 years ago with fundamental indexing, ballooning as a topic of research, and now weighting portfolios by risk characteristics, such as volatility, has become the mode du jour.

It can be distilled into the fact that empirical evidence shows that there are certain factors that drive returns. These include price to valuation, low volatility, size and momentum.

Smart beta is implementing that thinking, so a portfolio is tilted towards one or, in the case of AQR’s products, many of these factors. AQR identifies four styles of premia – value, momentum, carry and defensive – and combines them in seven different places including industries, countries and currencies.

The benefit to investors is that the veil is being drawn back on what were often previously thought of as active strategies, so now investors can see whether there is really manager skill involved and whether it’s worth paying for.

Many active managers figured out years ago that value and momentum were drivers of return. Investors were paying active fees for that knowledge, and a tilt towards a style premia, but what smart beta now demonstrates is that knowledge is not necessarily skill.

The development of academic thinking and tools, and the application of it, is providing clarity around alpha, or the lack of it, and hopefully more transparent and fairly priced offerings.

The age of style tilts

While I think I’m convinced that alpha does exist, I know that tilting towards, say, value, is not it. So investors shouldn’t pay an active fee for that.

I must add, however, while I see an eventually bright future in product development and appropriate pricing, I also see a plethora of products about to explode onto the market, which investors will have to wade through to get to any eventual Mecca.

Apparently there are now already as many indexes as there are stocks, and we haven’t even really started on style-tilted indexes, not to mention combinations of style tilts.

As this new wave of industry development continues, investors have a chance to make some demands. Expect innovation, expect transparency, expect to pay appropriately, and expect honesty. If you don’t get it, don’t do business with those organisations. It’s simple really.