Attraction to smart beta grows, as does complexity

Second generation spurs questions of portfolio balance

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Increasing: Ramon Tol says Blue Sky Group is considering putting 15% to 20% of equities in smart beta.

Updated with correction.

Smart beta is cutting deeper into traditional passive strategies and displacing more actively managed portfolios, according to consultants, managers and pension fund executives.

But the second generation of smart beta — also known as alternative beta or advanced beta - also introduces sharper tools for slicing beta, requiring more in-depth understanding of how these strategies combine within investment portfolios, consultants and academics said.

In the past year, specialist managers such as Research Affiliates LLC, TOBAM and Lombard Odier Investment Managers saw significant jumps in asset flows into their smart-beta strategies, despite a difficult environment for the overall asset management industry. While new mandates tended to be a shift from traditional cap-weighted indexes, some investors are using smart beta as an alternative to actively managed strategies, consultants said.

“The next question is how to balance the whole portfolio in terms of active vs. smart beta,” said Philip Tindall, senior investment consultant at Towers Watson & Co., Reigate, England. “Put it another way: How much of the active portfolio is effectively smart beta? That's a legitimate question to ask right now.”

Ramon Tol, fund manager-equities at Blue Sky Group Inc., Amstelveen, Netherlands, said executives at the fiduciary manager are considering increasing smart-beta exposure to 15% to 20% of the total equity portfolio. “That's about where we think it should be to have a meaningful impact on the risk-adjusted return of the overall equity portfolio,” he said.

Blue Sky Group, which invests about 40% of its e16 billion ($21 billion) in total assets under management in equities, already doubled its smart-beta allocation in September to 10% of the total equity assets, from 5%. Blue Sky Group uses three smart-beta equity strategies - “two minimum-variance mandates, including one with a slight dividend yield tilt and better performance in up markets, plus a maximum diversification strategy,” according to Mr. Tol. He declined to confirm the strategies' managers.

“We felt that 5% just doesn't have a meaningful impact on the overall risk/return of the portfolio,” said Mr. Tol, whose company is the fiduciary manager for KLM Royal Dutch Airlines pension funds among other clients.

As of the end of October, Towers Watson's clients already have added $3.3 billion in new smart-beta mandates globally compared with $3.1 billion for all of last year, according to data from the firm.

Accelerated inflows

Inflows among managers have also accelerated this year:

  • Research Affiliates, a specialist in fundamental indexing, added $15 billion — or about 27% — to $70 billion in fundamental index-related assets managed by the firm and its distribution partners in the nine months ended Sept. 30. (A total of $113 billion is managed worldwide using investment strategies developed by Research Affiliates.).
  • At TOBAM, a smart-beta specialist in maximum diversification strategies, global assets under management grew 60%, to $2.9 billion, so far this year , not including “a strong pipeline,” said Yves Choueifaty, Paris-based president and chief investment officer of the firm.
  • Lombard Odier saw a 41% increase to e3.2 billion ($4.142 billion) in AUM within its fundamentally weighted fixed-income strategies.

Among Lombard Odier's newest strategies is a global credit strategy that invests in crossover corporate bonds in the frontier between the investment-grade universe and high yield, said Stephane Monier, the firm's deputy global CIO based in Geneva. “This is where the rising stars and fallen angels meet,” said Mr. Monier, referring generally to BB- and BBB-rated bonds. “What we noticed is that the inefficiency in this part of the market allows for more potential for higher risk-adjusted returns.”

Smart beta generally refers to non-market-cap-weighted, systematic strategies that aim to add value — either by improving returns and/or providing lower volatility — compared with the market-cap index itself.

As demand grows, strategies are being developed to capture beta more precisely. For example, Towers Watson consultants have recently collaborated with managers to develop strategies including those focusing on listed infrastructure, low-volatility equity and fixed income, Mr. Tindall said.

“What we're looking to do is apply some of the ideas that went into smart-beta equity strategies to bonds,” Mr. Tindall said. “We're also looking further at hedge fund strategies that could be partly replaced by smart beta strategies, for example, merger arbitrage or convertible arbitrage.” Towers Watson advises clients with aggregate smart-beta assets of more than $18 billion globally.

One of TOBAM's largest clients, whom Mr. Choueifaty declined to name, has been increasing its mandate with TOBAM to $700 million now, from $200 million in 2008. “In the beginning, it was more of an experiment,” he said. “Now it's no longer about experimenting. It's (part of) the core allocation.”

In addition to recently launched emerging markets equities and commodities strategies, TOBAM will introduce a fixed-income strategy within the coming months.

According to an annual survey conducted by investment consultant bfinance International Ltd. published in November, 43% of the asset owners who responded said they were considering adding exposure to smart-beta strategies. That was up from 37% the previous year.

“Some of the larger schemes are using smart beta to make their core allocation work harder ... by replacing the core portfolio's pure passive (strategies) with an optimal blend of smart-beta indexes,” said Olivier Cassin, managing director and head of research and development at bfinance in London.

According to Mr. Cassin, exposure to smart beta should be at least 10% to 15% of the entire portfolio to have a lasting impact on its risk/return characteristics over a cycle, depending on investors' risk appetite.

Not distinguished

In a separate paper, Noel Amenc, London-based professor of finance at EDHEC Business School, writes that the first generation of smart-beta benchmarks is generally constructed from the stocks' economic characteristics and “do not distinguish the stock-picking methodology from the weighting methodology.” However, the second generation of smart beta “clearly” distinguishes between the two phases, enabling “the investor to choose the risks to which he does or does not wish to be exposed,” Mr. Amenc wrote. Data from EDHEC-Risk Institute reveal about 40% of investors surveyed in Europe and North America already adopted smart-beta indexing strategies.

Along with the added complexity, there also is a need for more informed decisions on the different risk factors to which investors are exposed, as well as a clearer understanding of the implementation process, Mr. Amenc wrote in “Beyond Smart Beta Indexation,” which was published last month.

For example, within low-volatility smart-beta strategies, investors should be cautious both on the timing of the implementation and the underlying considerations of the strategies themselves, sources said. If the low-volatility strategy uses an optimization approach, some unintended return factors might be embedded.

In launching a suite of four low-volatility smart beta strategies earlier this year, Research Affiliates set out to tackle some of the problems that exist with optimization-based approaches that currently dominate the market, including heavy exposure to a particular country or sector. Another potential setback with optimization-based strategies is a potential bias towards smaller-cap stocks, which could result in capacity and diversification constraints, said Michael Larsen, director and head of affiliate relations at Research Affiliates, Newport Beach, Calif.

Next on list of new strategies to be launched is a global corporate bonds index among other fixed income indexes. Mr. Larsen added: “The evolution from cap-weighted to smart beta is firmly established.”

This article originally appeared in the December 10, 2012 print issue as, "Attraction to smart beta grows, as does complexity".