Smart Beta 2.0: A Disruptive Innovation by Steven Vannelli, CFA, Eric Bush, CFA, Bryce Coward, CFA, and Jennifer Thomson, Gavekal Capital
At the beginning of ever major disruptive innovation, fear, uncertainty and doubt reign supreme. Consumers are fearful of the unknown, uncertain of the benefits and doubt the durability of the innovation. But, in the end, fear, uncertainty and doubt give way to confidence, understanding and acceptance. The fund management industry is on the cusp of a major disruptive innovation.
In “Smart Beta 2.0: The Next Battleground for Asset Management Dollars Heats Up,” Moody’s describes how “asset managers are accelerating their expansion in the smart beta space, as alternative index strategies become more sophisticated and gain broader acceptance.”
The report continues: “This accelerating activity has coincided with a shift in the evolution of smart beta products from the basic – simple and static security selection and weighting schemes – towards the development of more sophisticated products that are based on multiple factors and timing of exposures. Smart beta’s next phase – call it ‘smart beta 2.0’ – will be more research intensive.
“This next phase will likely place smart beta funds in direct competition with traditional mutual funds … In a sense, smart beta 2.0 will evolve into a more disciplined and cheaper form of active management – that is, it will attempt to achieve the goals of traditional active managers, but at a lower cost and with more consistency in terms of adhering to a set of investing rules.
“Those most at risk are traditional mutual funds with highly diversified portfolios whose performance closely tracks, and typically lags, the index – e.g., closet indexers with over 100 securities in their portfolios. The AUM loss from these firms could directly accrue to asset managers well-positioned to offer the next iteration of smart beta funds.”
Smart beta is a disruptive innovation for investors. The promise of smart beta is excess returns in a cheaper, simpler and more predictable way. Before now, only mutual funds managed by humans could boast the potential for excess returns—and, if and when they did generate alpha, it was not necessarily repeatable: there were more unknowns, higher fees and higher taxes. Smart beta aims to capture these same excess returns in a cheaper, transparent and predictable, rules-based way.
Passive vs. Active vs. Index Realities
The emergence of ETFs in the 1990s allowed investors to invest mechanically in broad equity market segments for the first time. Previously, most assets in the United States were actively managed by investment managers. Over time, investors began to view the decision to invest in an index fund as a “passive” investment, and the decision to hire a portfolio manager via a mutual fund as an “active” investment. The emergence of smart beta funds has blurred the lines.
Today many view a fund following an index as a “passive” investment, which doesn’t quite tell the whole story. In “Indexes Can Be Passive, Active Can be Indexes, but Passive Can’t Be Active,” John Rekenthaler describes Morningstar’s approach:
“Historically, active and index investing have been viewed as binary events. A fund is either one or the other… It is fine to place exchange traded funds and indexed mutual funds into the same index group, and put all remaining mutual funds into the active group… Although even then, a third set is helpful. There’s a difference between indexes that weight securities according to market capitalization… and indexes that incorporate viewpoints… By our reckoning, the active/index duo should expand to three: 1) actively managed funds, 2) index funds weighted by market cap, and 3) strategic beta index funds.
“Let’s switch from discussing active vs. passive to active vs. index. Those are not the same things because passive is not a synonym for indexing. A passive fund is a fund that does not express a viewpoint. An index fund is a fund that mimics a list of securities. Those are two different things. Thus a strategic beta fund is an index fund, but it is not a passive fund.”
Let’s start by decomposing the terms passive and active management. A passively managed fund is designed not to take a viewpoint, as Rekenthaler put it, which means that passive funds follow benchmark indexes like the S&P 500 or MSCI World Index. When he says that passive funds don’t have a viewpoint, what he means is that they simply own all the stocks in a benchmark index, in the exact same weight. No human decisions are made in a passive fund. As the index changes, the fund is similarly adjusted. The fund performs almost identically to the underlying index, minus fees.
Traditionally, an actively managed fund is managed on a discretionary basis by a portfolio manager to achieve results relative to some benchmark. Portfolios usually represent a small fraction of the companies in the reference benchmark. Changes to the composition of the portfolio occur continuously as the portfolio manager adjusts the portfolio to pursue opportunities. For actively managed funds, performance tends to deviate from the benchmark, sometimes better and sometimes worse, minus fees.
A new form of active management has emerged, called smart beta. Smart beta ETFs are designed to follow an index, but that index is different than a benchmark index. Smart beta indexes do take a viewpoint on markets and express that viewpoint by a selection and/or weighting scheme that differs from a benchmark index. If we consider the true “activeness” of a fund—as we will discuss in the next section—rather as the extent to which a portfolio differs from a broad benchmark, then we can much more effectively analyze a fund’s true contribution to an overall portfolio.
Morningstar’s Rekenthaler goes on to describe the evolution of the fund management industry since 1994: “Active management dominated for the first 10 years … market indexes took control after the 2008 market crash and has never looked back; and … strategic beta, the newest member of the troika, is rapidly becoming a major force.”
Understanding Active Share
Thanks to the work done by Martijn Cremers and Antti Petajisto, investors now have a tool to measure how “active” a fund really is. Active share is a percentage (ranging from 0% to 100%) for long-only funds that measures how different a fund’s holdings are from the benchmark holdings. Cremers and Petajisto combine active share with tracking error to devise four types of active management styles: 1) closet indexer, 2) factor bet, 3) diversified stock picker, and 4) concentrated stock picker. Many actively managed funds, it turns out, tend to hold a portfolio of stocks that look very similar to the reference benchmark.
A closet indexer holds a portfolio that is nearly identical to the benchmark. These actively managed funds charge a higher fee, commensurate with an actively managed fund, for what is in essence a passive product. Closet indexers can be identified by their very low active share and very low tracking error. Not surprisingly, from 1990-2009, the authors found that after fees, these funds had the worst performance among all active asset managers.
Factor bets are actively managed funds that invest based upon systematic risk factors. These types of funds may invest in an entire industry or sector or use a timing rule to tactically move in or out of cash or other assets. Factor bets tend to have a high tracking error but a relatively low active share due to holdings which resemble the composition and weighting of the benchmark. Strategies that use ETFs exclusively for equity exposure often fall into this camp. The authors found that these funds sometimes can beat their indexes but for the most part, any outperformance disappears after fees.
Diversified stock pickers have a high active share and a low tracking error. They own a diverse portfolio of stocks, which allows them to achieve great deviation from the benchmark index. By extensively diversifying, they can eliminate much idiosyncratic risk. Many high ranking actively managed mutual funds fall in this category. The authors found that diversified stock picking funds consistently outperformed the benchmark after fees.
Last, the concentrated stock pickers have a high active share and a high tracking error. Concentrated stock pickers combine the best attributes of factor bets and diversified stock pickers by “taking positions in individual stocks as well as systematic risk.” This is a unique group, populated by high return, low risk allocation-style funds. Cremers and Petajisto found that concentrated stock picking funds consistently outperformed the benchmark after fees.
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