Thought Leadership (Professional Only)

Is there a smarter alternative to smart beta

Lower returns and high costs have prompted many institutional investors to re-examine the way their money is managed. Their first port of call has often been passive management, which has seemed to offer a cheap route to good performance.

14 July 2014

Lower returns and high costs have prompted many institutional investors to re-examine the way their money is managed. Their first port of call has often been passive management, which has seemed to offer a cheap route to good performance. Unfortunately, passive approaches have their own set of problems. More recently, smart beta has been proposed as a better way of achieving investors’ goals, promising the alpha of active management at a cost more akin to that of passive portfolios. But smart beta is not quite the panacea that it appears to be either. We asked Tim Matthews, Client Portfolio Manager in our QEP Investment Team, to discuss some of the challenges facing investors.

Q. What led active investors to look for alternatives?

The market upheavals of 2007–8 acted as a catalyst for smart beta strategies. Suddenly investors became preoccupied with the risks inherent in their investments. They no longer searched for the best performance; they now became much more interested in getting the best return for each unit of risk they took on. Their measure of success moved from being simply their outperformance against a stock index to their information ratio, the outperformance divided by the standard deviation of that outperformance (or ‘tracking error’). Passive strategies already seemed to offer consistent performance at low cost, but smart beta took the passive approach and added new features that promised to improve performance further still.

Q. So what’s wrong with passive management?

It’s important to be clear that there are many benefits to investing passively using traditional market-capitalisation benchmarks. They include diversification, transparency, and what can be a cheap way to gain access to the equity market. However, while passive strategies may be systematic and transparent in their construction, these features also make them inherently anti value, since they encourage investors to buy high and sell low. They can also lack breadth and effectively restrict the investor to the largest stocks in the investment universe. This concentration on the largest stocks means that the diversification benefits are often more apparent than real.

Q. What do you mean by concentration?

In certain market environments, market capitalisation weighted indices are dominated by a relatively small proportion of the market. For instance, in February 1989, 44% of the MSCI World Index – which represents the largest global stocks – was composed of Japanese stocks. In February 2000, technology and telecoms stocks made up over 35% of that same global index. In both cases, those two parts of the market – Japanese stocks and the technology and telecoms sector – underperformed badly in the subsequent period. Indeed, research shows that the larger and apparently safer stocks that often dominate cap-weighted indices generally tend to underperform in the long run.

Q. And what about lack of breadth?

We think index-bound investors restrict their investment choices unnecessarily. For instance, while the MSCI World Index is currently composed of over 1,600 stocks, we would argue that the universe of global stocks with sufficient liquidity to allow efficient access by investors comes to more than 15,000 stocks. This includes over 4,000 in emerging markets which are potentially attractive and suitably liquid, but are not represented in the MSCI World Index, restricted as it is to the developed markets. Similarly, the overwhelming bias of the MSCI World Index towards the largest stocks means that only 2% of the index comprises mid-size stocks. In fact, using our 15,000 stock universe, the 1,600 stocks in the MSCI World represent only a small proportion
of the available stocks by number, with a further 30% or so each in the mid-cap and small-cap segments and 24% in the micro-cap category (see Figure 1). So we would argue that there is a huge range of untapped stocks beyond the reach of the index.

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