The ability to separately offer the different elements of investment return – beta, strategic beta and alpha – is a growing and important trend.
The concept of unbundling isn’t new; many industries are beginning to break apart their packaged offerings. The cable TV industry, for example, is a place where consumers are opting out of the full package — buying internet service and other entertainment elements separately. The ability to offer investment services in the same way is important. Colin Moore discusses the three components that make up investment return.
We’ve been discussing this concept of unbundling for some time.
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There are really three things that make up the return that you get from an equity product. There is nothing new in this. Perhaps our ability to analyze and identify them is better, but these conditions have existed for all the decades that I’ve been in this industry.
So the first one is known as beta. And all that is is really the sensitivity to any equity product, to what’s going on in the broad marketplace. The easiest one to think about is the S&P 500. If the S&P 500 rises by 10%, and your product generally rises by 110% of that, i.e. 11%, then you’ve got a beta of 1.1.
There’s another element which is today known as smart beta, but for many decades was simply known as factor investing. That is less common. It is less prevalent in the return. But it is there and it’s fairly persistent. Easiest way to think about that is a lot of funds have bias towards value versus growth or size. A small cap fund versus a large cap fund. But there are other factors such as momentum or quality that are all there. Less visible to many investors, but they’ve been there for many years and certainly they are things that we exploit in our day-to-day business in trying to help our clients.
Then there’s this other element to it which is much more rare, but also much more valuable, called alpha. And that is where you create part of the return that’s not based on these market sensitivities or factor sensitivities that I mentioned earlier, like value or growth. There is something unique about the investment you make that creates this what’s known as idiosyncratic return. It’s not explained by anything else, and also it tends not to be correlated to other things that are going on.
So what we’re realizing now is that we need to be able to offer those services to people in the same way that other industries are beginning to break apart their packaged offerings. The analogy we’ve used is the cable TV industry, that people don’t necessarily just buy the full package any more. People now buy the internet service and add what other elements they want for their entertainment. We will increasingly see investment products in the market place that are unbundled.
Article by Colin Moore, Columbia Threadneedle Investments