Smart Beta – A compelling shade of grey?
posted on May 22nd, 2015 by David
‘Smart Beta’ is one of the real buzz words in markets right now. Peter Bell provides an overview of this rapidly growing area, and explains why Smart Beta and Managed Accounts work so well together.
Broadly speaking, most advisers have fairly similar objectives for their clients’ exposure to the equity markets – high returns, low fees, simplicity, and for those more sophisticated advisers – tax efficiency as well. The only question is how to best achieve this often conflicting mix of objectives. Does the simplicity of a managed fund outweigh the tax inefficiencies and lack of transparency of the structure? Is the transparency and tax effectiveness of a direct equities portfolio worth the compliance and administration headache it creates? Are the higher fees for an actively managed fund justified by the returns they generate relative to the index? And even if an active manager does outperform the index before tax, will their turnover lead to poor after tax returns?
When navigating the investment landscape with these broad goals in mind, advisers have traditionally been faced with ‘black or white’ choices – managed funds, or direct equities; active management, or passive index strategies. Today though, a new generation of structures and strategies exist, that combine the best attributes of each of the traditional approaches to provide a compelling alternative for advisers and their clients.
In terms of holding structure, Managed Accounts have evolved to occupy the middle ground between traditional share portfolios and managed funds. By combining the professional investment management and simplicity of managed funds, with the tax efficiency and transparency of a direct share portfolio, managed accounts effectively provide the best of both worlds – and are finally starting to exhibit the growth that their superior structure warrants.
In a similar vein, the traditional debate in terms of investment strategy has centred on the ‘passive vs active’ debate – with both sides arguing vociferously of the benefits of their particular approach. In a similar way to Managed Accounts, Smart Beta has evolved as the middle ground between the traditional alternatives. Like active management, Smart Beta strategies aim to outperform the market over time, but they do it in a way that draws more parallels with indexing than with traditional active management.
Theoretically at least, the case for active management is compelling. An active manager, through their intensive research, experience and analysis will aim to position their portfolio to benefit from the above average growth and income generated from a selection of stocks that are underpriced relative to their future prospects. There is no question that market prices are far more volatile than the intrinsic value of the underlying businesses being traded (or the aggregate future earnings potential of the market as a whole for that matter), so it’s logical to assume that these excessive movements provide opportunities for intelligent managers (and they are on average an exceptionally intelligent bunch!) to profit from these irrational movements.
Unfortunately, the evidence suggests that it isn’t quite that simple. For more than 80 years, studies have been showing that actively managed equity funds tend to underperform the market capitalisation weighted indexes that they’re benchmarked against, over almost all timeframes, in virtually all markets around the world. One of the most consistent demonstrations of this underperformance is shown in the annual S&P Index vs Active (SPIVA) study, that looks at the performance of actively managed funds compared with their benchmarks, over short, medium and long terms, and in markets all around the globe. In their most recent study, at 31st December 2014 they found that over the past 5 years 89% of US large cap fund managers under-performed the index, while in Australia 78% of large cap funds failed to match their benchmark, and in Europe 74% under-performed. The evidence is incontrovertible – despite their best efforts, extensive experience, and the vast resources at their disposal, on average active fund managers have been unable to even keep pace with the market, let alone outperform it!
This result would come as no surprise to disciples of the ‘Efficient Market’ school who, driven by groundbreaking academic research in the 1960’s and 1970’s have long been arguing that investors are perfectly rational, share prices accurately reflect all available information about a firm and its prospects, and the most efficient portfolio is therefore the market portfolio. The combination of this compelling academic theory, and the long history of real world underperformance of professional investors lead to the single biggest movement in investment management of the last 50 years – the emergence of indexing. If active management didn’t add value, and the most efficient portfolio was actually the index portfolio, then the logical conclusion was to invest in a fund that tracks the index at the lowest cost possible.
From humble beginnings in 1976, today well over USD$3 trillion is invested in index tracking funds, with an incredible 86% of all managed fund inflows in 2013 going into passive index tracking strategies according to a recent Morningstar study. With more competitive fees, lower turnover and better performance than traditional actively managed funds, this trend has undoubtedly added vastly to the wealth of investors worldwide. But the question remains – is it optimal?
Finance research has come a long way since the 1970’s, when the seeds of the indexing revolution – the Efficient Market Hypothesis (EMH) and Capital Asset Pricing Model (CAPM) – ruled the academic roost. We now know that investors are not always rational, and markets not always efficient. In fact, Eugene Fama (father of the EMH ironically!) won a Nobel Prize in Economics, in part for his 1992 research proving that a portfolio’s return could not be explained solely by its sensitivity to market movements (as suggested in the CAPM), but depended also on its exposure to two additional factors – ‘value’ and ‘size’. By increasing their exposure to either of these ‘factors’, investors could increase their returns without a corresponding increase in their risk – a result that flies directly in the face of the Efficient Market Hypothesis. The academic literature today abounds with studies verifying the existence of these factors and their effect on portfolio returns, as well as identifying other factors (including ‘momentum’, ‘size’ and ‘low volatility’) that collectively serve to undermine the foundation on which the indexing movement has grown.
In examining the evolution of Smart Beta, it is the ‘value’ factor that is particularly relevant – because it is here that the critical difference between traditional passive indexing strategies and the Smart Beta approach exists. Distilled to its simplest form, the crux of Fama and French’s findings in relation to the ‘Value’ factor was that on average, stocks that traded on low Price to Book ratios tended to outperform stocks trading at high Price to Book ratios. Whilst this outperformance does not occur in every year and from time to time can suffer extended periods of underperformance, their research has shown that on average ‘Value’ stocks have outperformed the market consistently for over 80 years.
Follow up studies by other academics have yielded similar results in relation to all manner of valuation multiples, including earnings, sales, dividends and cashflows – with the commonality being that stocks trading on low multiples of their fundamental values tend to outperform stocks trading at high multiples of their fundamental values. This of course makes intuitive sense – over time, cheap beats expensive. Yet market capitalisation weighted indexes by definition reward highly priced companies with larger weightings, while punishing lower priced ‘Value’ shares with lower weightings.
As an example – Let’s assume a simple market, with only 3 companies – A, B and C, each with 1 million shares on issue, and $1m in earnings:
As you can see in this simple example, with a market capitalisation weighted index, the more expensive a company is, the greater a weighting it constitutes in the index, and vice-versa – the cheaper a company becomes, the less exposure investors have to the company. Not only is this intuitively wrong, but it is the exact opposite of the optimal exposure as identified by the academic research – which suggests holding higher weightings in cheaper, ‘Value’ companies, while reducing exposure to more expensive companies.
Yet this significant shortcoming of market capitalisation weighted indexes is far from being only a theoretical issue either. Whilst at a micro level these unseen inefficiencies subtly detract from investors’ performance, every so often markets reach extreme valuation levels that serve to graphically illustrate the folly of this approach. In one of the most striking examples, during the tech bubble of the late 1990’s the IT sector almost tripled its weighting in the S&P500 during the two years from 1998 to 2000, reaching an incredible 34.5% of the index at its peak. Any unfortunate investors following an indexing strategy in this market would have had a massive 34.5% of their portfolio invested in such wonderful opportunities as Cisco (then trading at a PE of 127) or Novell Networks (trading at a PE of 281). At the very point that the technology bubble reached its peak, investors following a market capitalisation weighted method would have had their highest ever allocation to the sector – of over a third of their total portfolio!
And it’s this fundamental inefficiency of market capitalisation weighted indexes that Smart Beta strategies attempt to overcome. They use alternative methods of stock selection and weightings, that still provide broadly diversified ‘beta’, but do so in a smarter way than the inefficient market capitalisation weighted method.
Just as Managed Accounts draw from the best components of direct ownership and managed funds, Smart Beta borrows some elements each from active management and traditional indexing. Like an active manager, Smart Beta approaches aim to outperform the market over time. But they do it in a way that’s much more akin to the indexing approach than typical active management strategies. The approaches are systematic – not relying on the judgements of individual portfolio managers, but driven by objective quantitative measures such as volatility, variance and valuation multiples – rather than just market capitalisation. They typically exhibit far lower turnover than their actively managed counterparts, although usually higher than that of market cap indexes. And they tend to be relatively low cost, with their systematic approach allowing for more cost effective implementation, leading to management fees that are far closer to index ETF’s than traditional active managers.
Whilst the approach has had its naysayers (not surprisingly, given the threat that its emergence poses to both active and traditional passive investment managers), its growth in the last 10 years has been nothing short of spectacular, with Morningstar recently counting 342 Smart Beta (or Strategic Beta as they prefer to call it) funds in the US market, with 59% growth in Assets Under Management in 2013 alone, to an impressive $291b.
Interestingly though, take-up so far appears to have been limited to managed fund implementations, with our Bellmont Core Equities Portfolio that was launched in April 2014 being the first Australian managed account model portfolio to adopt a Smart Beta strategy. Yet Smart Beta strategies are actually ideally suited to a Managed Account environment, as one of the key attributes of the Smart Beta approach – low turnover, can in fact be a double edged sword if implemented through a traditional unitised managed fund structure.
One of the well known drawbacks of unitised managed funds is the pooled ownership structure, that among other things, can penalise investors with inherited capital gains tax (where any capital gains tax attributable to the unit trust is passed through to the end investor, regardless of whether they themselves have benefited from the capital gain). Paradoxically, this issue is compounded by the low turnover of Smart Beta strategies, as the long average holding period for the underlying investments (which is the inverse of the average turnover) leads to larger capital gains when turnover does occur, and a greater likelihood of there being a mismatch between realised capital gains in the trust, and those of the end investor. By implementing such a low turnover strategy through a structure that allows the investor to enjoy full beneficial ownership of the underlying investment (either a managed account, or direct account), this mismatch is removed, and the investor is able to fully enjoy the considerable benefits of the Smart Beta approach.
1. Cowles, A. (1933). Can Stock Market Forecasters Forecast? Econometrica, 1, 3, pp 309 – 324.
2. Luk, P. (2015). SPIVA Australia Scorecard, McGraw Hill Financial