Smart Beta – The Latest Passive Investment Trend – 2Q15

06/19/2015

Passive investing is the investment of assets into an investment vehicle designed and mandated to track a particular index. The most tracked index in the world in terms of assets and investment product offerings is, of course, the S&P 500 Index. Other examples could be the Russell 2000 Index (small cap domestic equity), the Barclays Aggregate Index (total domestic fixed income), or the MSCI EAFE Index, which is the standard institutional international equity index.

The reason passive investing has gained momentum is twofold:

1. Passive investing is typically less expensive than active portfolio management. Tracking an index, which locks in the index performance less fund expenses, is not nearly as cost-intensive as actively making stock selection and sector bets in order to attempt to outperform the index. It is just important to understand and apply the construction methodology of the index while minimizing dispersion from that index to the extent possible.
2. The recent market environment has not been conducive to active management relative to benchmarks. This is because the markets have achieved consistent upward trending performance since the 2008-2009 financial crises in a generally low-volatility environment. Without that market volatility, it is generally more difficult for managers to make investment decisions that generate the excess return needed to outperform the index less fees.

Both of these points are valid. However, when it comes to active versus passive investing, the optimal solution is like most things: somewhere in between. Passive investing can be appropriate in efficient asset class spaces such as large cap domestic equity. There is not a lot of public information unknown about the largest companies in the United States, which makes it difficult for analysts and portfolio managers to distinguish themselves while maintaining a reasonable risk profile. There is less excess return to be had in this space, and the risk/return trade-off to achieve that excess return is not always worth it in a benchmark-comparison environment.

For asset classes such as small cap equities or emerging markets, which are much less efficient (i.e., less information is widely disseminated about these companies), managers have many more opportunities to make stock and sector bets that can achieve healthy excess risk-adjusted returns. Higher tracking error is accepted and expected in these spaces.

Therefore, an approach where potentially both investment styles are employed may be the right mix to construct an institutional portfolio: index in the efficient spaces and use active managers in the less efficient asset classes.

Smart Beta

Within the world of passive investment options, competition is naturally heating up. Initially, there were a few large investment firms that were indexing at an early stage and thus created or achieved the rights to the most well-known indices in the world. This was lucrative for these firms and created barriers to entry for other firms to capitalize on the growing market.

In an attempt to enter the market, firms began to offer variations, twists or differing methodologies on an index through Exchange Traded Funds (ETFs). So while State Street had the exclusive rights to the S&P 500 Index through their popular SPDR ETFs, which track the exact methodology of the S&P 500 Index, other firms entered the market by offering ETFs that included the same companies as the S&P 500 but employ a different methodology.

While the S&P 500 Index methodology is based on the market capitalization of the companies that make up the index (i.e., Apple, Inc. has the greatest weight in the index because it is the largest company), other firms created a product based on each company having an equal representation of the index. So Apple, Inc. would share the same allocation in the index as the smallest of the 500 companies in the S&P 500.

Firms will create these products based on back-tested results of historical prices and extrapolate from that why this is a better methodology than the actual S&P 500 Index methodology. However, as we are all well aware, past performance is not indicative of future performance; therefore, there is nothing to suggest that a different methodology will outperform going forward. Other metrics and factors used to create differing methodologies may be earnings per share (EPS), dividend yield, price- earnings ratio (P/E), etc.

From an institutional product manufacturing perspective, asset management firms have come out with a new term for this type of investing: Smart Beta. Investopedia.com defines Smart Beta as:

"...a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization-based indices. Smart Beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of Smart Beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as seeking to enhance risk-adjusted returns above cap-weighted indices.

Investment managers that follow a Smart Beta investment strategy seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility. That’s because Smart Beta strategies are implemented like typical index strategies in that the index rules are set and transparent. Smart Beta strategies will differ from standard indices, such as the S&P 500 or the Barclays Aggregate, in that the indices focus on areas of the market that offer an opportunity for exploitation."

Source: www.Investopedia.com

Conclusion

With the hold that just a few companies had on the actual index methodologies and the increased popularity in using ETFs, the proliferation of these products has grown exponentially to where there are now even actively managed ETFs. Some would argue that this may be the way of the future in that mutual funds will go to actively managed ETFs available to trade on an exchange intra-day versus the current method of end-of-day pricing.

While this has investment theory behind it and is something that may be customizable to reduce an institution’s overall portfolio risk, it is also being viewed in a skeptical light by some. It may ultimately result in an investing trend or fad that falls by the wayside in a couple years like Portable Alpha and 130/30 portfolios.

There will always be asset managers who manufacture products or strategies to increase growth in assets under management. In order to spark growth, there must be a bit of marketing buzz that the new idea will bring a cutting edge investment theory to the market. Time will tell if Smart Beta can last.

For more information, please contact your Fifth Third Bank Client Consultant.

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