Smart beta investing remains a hot topic in our industry’s forums, conferences and specialist journals. However, what began as a mere revolt against the dubious hegemony of 'traditional' index-driven asset management is starting to turn into a structural and sustained revolution in institutional investors’ strategic allocations with much at stake. Drawing on the extensive experience BNP Paribas Asset Management (BNPP IP) has acquired in this field, Étienne Vincent reports on the skirmishes and describes what’s at stake for the factions currently battling over the spoils.
The origins of the uprising
A certain disaffection, after the great financial crisis (GFC) of 2008-2009, with traditional active management gave rise to the initial interest in smart beta as an investment approach. The catchy name – smart beta – capitalised on the booming market share that index funds and exchange-traded funds (ETFs) had acquired over the previous 10 years (see exhibit 1 below). These funds offer transparency and extremely low fees relative to traditional actively managed funds. However, smart beta developed and refined the argument according to which traditional market-cap-weighted indices are inefficient as a benchmark for passive investment. The use of these indices in the asset management industry, of course, goes back a long way - they remain widely used in many types of investment management. Nonetheless, in the wake of the GFC, an argument in favour of simplicity and efficiency had considerable appeal and subsequent developments of the approach met with strong interest from investors.
Exhibit 1: Global ETF and ETP growth between 2005 and October 2015
Source: etfgi as of October 2015
The highly competitive world of index and ETF producers has warmed to this theme to extend their product range, whereas, in principle, these strategies are neither ‘passive’ nor short-term. On the contrary, moving away from market cap-weighted indices requires significant portfolio rotation and there is little correlation between intraday liquidity and long-term returns.
Extension of the revolt
As we noted in the article “Demystifying risk-based strategies” published in 2012, there is nothing magical about the attractive potential returns offered by these factor-based investment strategies. The sources of the returns are well-known factors, in particular the low-volatility anomaly. That’s why we have developed co-mingled funds in this area and have worked hard to make investors more aware of this often overlooked factor.
However, given that this is not the only performance factor, it is of course possible to devise strategies based on other recurring outperformance factors such as value, momentum and quality. Each of these factors comes with its own specific risks. To transform a factor into a strategy, there is a broad range of methods. They are all the result of trade-offs between the quest for performance from this factor and its inherent constraints or risks.
For example, the value factor, which consists of buying cheap shares in the expectation that they will rise in price, can be based on many different corporate balance sheet indicators, on long-only, on long-short or on under- or overweighting of securites relative to a benchmark. Securities may be weighted by how expensive or liquid they are or by their market capitalisation. The absolute risks or those risks relative to the original index may be mitigated by filters or optimisation. It is this diversity that has given rise to the many factions among the smart beta revolutionaries.
Confused ? You are not alone…
Many investors are bewildered by this crowd of players and methods. Will the revolt suffocate in its own internal dissensions? Quite possibly. Some believe that growth in smart beta assets under management is leading to overpopulation that will drive out alpha. Based on this argument, smart beta is destined to become merely another passing fad in our industry. In our view, this analysis does not take sufficiently into account the fact that most of our industry is now benchmarked to traditional indices and will probably remain so for several decades to come. Moreover, the very diversity of approaches offers protection from possible overcrowding - we are not all trying to get into the same theatre.
Even so, and assuming several valid sources of smart beta, there is still the thorny question of how to combine them. How should each source of smart beta be weighted? What benchmark should be used? How can they be inserted into a strategic allocation? For the moment, two strong factions appear to have emerged – one comprising partisans of index management, the other being investment consultants.
According to partisans of index management, a single supplier’s range should be employed to ensure consistency between factors. Consultants favour an approach based on themed sub-asset classes to be able to manage risks and ensure competition between offers. It is easy to see the marketing forces at work behind these arguments.
And yet, neither of these two approaches truly responds to investors’ questions, given that they aim to separate the different factors, even though it is precisely through their complementarity that they draw their strength, i.e. the stability of the alpha generated and the management of overall risk.
Heading for a bright future
In June 2015, Raul Leote de Carvalho of BNPP IP’s Financial Engineering department presented a revolutionary way of combining several alpha factors within the same portfolio by separating the constraints to be factored in. This approach is especially well suited to constructing a 'multi-smart-beta' portfolio, i.e. a single portfolio exposed to several sources of systematic alpha in proportions set by the risk budget and defined in terms of tracking error compared to their starting index. For example, this methodology can be used to devise a strategy targeting a total 5% tracking error, of which 60% is assigned to low volatility, 20% to value and 20% to momentum.
Compared to the approach that involves stacking several separate single-factor smart beta allocations, this method offers several advantages. First, the pooling of constraints reduce their overall cost. Second, risk management is improved, as it is the total risk that is managed. And lastly, this methodology can be used ex-post to attribute performance directly to the true factors in returns.
Of course, such an approach is structural to the portfolio’s entire philosophy as it requires explaining risk allocation choices, which is an eminently dangerous topic. But isn’t it precisely the acceptance of risk that marks the boundary between a revolt and a revolution?