Managers see smart beta pickup among institutional investors

Smart beta's popularity among institutional investors has grown substantially in the past couple of years — and experts believe that will continue in 2014 and beyond.

Because smart beta is not yet an official designation, and because investors and money managers have different names and definitions for the strategies that fall under the name, it's difficult to quantify growth.

Whether it's called smart beta, advanced beta, exotic beta, strategic beta or factor-based investing, this set of equity and fixed-income strategies based on non-cap-weighted indexes appeals to investors seeking competitive returns in a cost-efficient manner.

Data from Towers Watson & Co. shows its institutional investor clients made more than twice as many new investments in smart beta strategies during 2013, approximately $11 billion, than the year before. All told, Towers Watson's clients globally have now allocated more than $32 billion to smart beta strategies.

“Up until five or 10 years ago, investors only had the option of passive or active investing,” said Fabio Cecutto, a senior investment consultant in Towers Watson's New York office. “However, there's always been academic evidence suggesting that there's been ways to exploit market inefficiencies.”

Lynn Blake, chief investment officer of global equity beta solutions at State Street Global Advisors, Boston, said that SSgA has seen its smart beta business increase by roughly 25% during the past three years.

SSgA's recent research also shows investors see advanced beta as more of a replacement for active strategies than passive and are three times more likely to fund a smart beta allocation from active than from passive.

The Oregon Investment Council, which runs the $67.1 billion Oregon Public Employees Retirement Fund, approved three smart beta allocations over the past 2½ years, accounting for nearly $2 billion.

“We like active management, but these rules-based factors offer a dependable, lower cost alternative to many active funds, especially when implemented internally,” said Michael Viteri, senior public equity investment officer for the investment council in Tigard.

While Oregon manages its smart beta portfolios internally, not all investors have that ability, so money managers are poised for that opportunity.

At BlackRock Inc., “we are seeing more clients asking questions about this category,” said Amy Schioldager, New York-based senior managing director and global head of beta strategies.

According to Ms. Schioldager, BlackRock, which manages approximately $45 billion in what she calls strategic beta, started seeing investor interest in low-volatility strategies in 2009 following the financial crisis. Clients were seeking protection on the downside yet wanting to participate in the equity markets. So, the firm launched its first strategy benchmarked to minimum volatility indexes in 2010.

Now, the firm's clients are using this strategic beta to complement their traditional index strategies.

“We're seeing it being used across the full spectrum of markets: across equities, across emerging markets (equities), across developed markets,” she added.

Said SSgA's Ms. Blake: “In the last five or six years, there's been an even stronger demand for smart beta, in particular for low-volatility and valuation-tilted strategies.”

She added that part of the appeal of such strategies is that “they're very rules-based, objective and transparent,” and that the fees “are significantly lower,” which helps with performance.

Although fees for smart beta strategies are lower than for active strategies, clients will pay a premium compared to traditional passive management. Through smart beta, however, investors can achieve investment performance in a way that meets their investment objectives. Disappointment with the costs and performance of active management, according to Ms. Blake, is among the main reasons investors switch to smart beta.

SSgA, which specializes in passive management, manages $72 billion in what it brands as advanced beta strategies.

Robert Deutsch, managing director and head of global liquidity at J.P. Morgan Asset Management in Newark, Del., described smart beta as “a strategy that chips away from market-cap weighting.” The firm filed documents with the Securities and Exchange Commission for three exchange-traded funds based on these kinds of strategies in February, marking its move into the U.S. smart beta market.

J.P. Morgan Asset Management manages about $2 billion in alternative beta strategies in the U.K., said spokeswoman Kristen Chambers in an e-mail.

“We've had this trend of asset managers moving assets from active to passive. Smart beta has only caused that trend to accelerate,” said Michael Larsen, director and head of affiliate relations at Research Affiliates Inc., Newport Beach, Calif. As of Dec. 31, $166 billion in assets was linked to Research Affiliates' strategies, $121 billion of which went to its Research Affiliates Fundamental Index smart beta strategies.

“There's a much greater acceptance that cap-weighted indexes aren't the best way to invest in equities,” said Eric Shirbini, global product specialist in London with EDHEC-Risk Institute's smart beta unit, ERI Scientific Beta.

One problem with cap-weighted indexes, according to Mr. Shirbini, is that net of fees, active managers tend to underperform.

“That's where smart beta comes in,” he said. “The fees for smart beta are more comparable to passive than active management.”

The EDHEC-Risk Institute launched its smart beta platform in April 2013 and has had a total of 27,000 users, 500 of which are regular users. Money managers can customize benchmarks and choose different risk exposures by manipulating the nearly 3,000 indexes on the platform.

“Cap-weighted indexes are not efficient from a construction point of view,” said Adrian Banner, CEO and CIO, INTECH Investment Management LLC, West Palm Beach, Fla. “You can get the same return for a lower risk (with smart beta).”

INTECH's managed $47.6 billion as of Dec. 31, all in the category of smart beta.

“It's a cost-effective way to get a target exposure,” said Jay Love, an Atlanta-based partner and senior consultant with Mercer. Through smart beta, investors can either “get lower volatility or try to capture some mean conversion.”

Not all managers, however, are buying this.

“Smart beta, quite frankly, is just a marketing term,” said Joel Dickson, investment strategist at Vanguard Group of Cos. Inc., in Malvern, Pa.

According to Mr. Dickson, there is nothing new about smart beta, besides the terminology. What is new, he believes, is a “move away from the categorization of equities by style box ... now strategies are being delivered on a single factor,” such as valuation, momentum or dividend. Not surprisingly, Vanguard does not classify any of its assets under management as smart beta.

“A lot of what's being called smart beta is really "fauxdexing.' We think it's a complete mislabeling of a different form of active management,” Mr. Dickson added. “It's a Halloween costume; a rebranding of active management.”

But that viewpoint seems to be in the minority among consultants and managers.

“There is continued interest and that interest is defined by RFP activity,” said Gary Chropuvka, a managing director at Goldman Sachs Asset Management and head of its customized beta strategy team in New York. “We believe that (smart beta) will continue to be of interest for investors.”

GSAM had approximately $26 billion in customized beta strategies as of Dec. 31. Mr. Chropuvka said GSAM saw RFP activity for smart beta strategies increase by more than 30% from 2012 to 2013. For the most recent calendar year, approximately one of every five searches was for a smart beta strategy.

“I've seen a pickup in the number of conversations that we're having in the space as more people are reading about it, hearing about it, and learning about how to use it in their portfolios,” said BlackRock's Ms. Schioldager. “So I would say that the trend is increasing.”

“The idea that the cap-weighted index is not the most efficient scheme is probably here to stay,” noted INTECH's Mr. Banner. n