In general, academics' work in factor-based approaches shows concepts active managers have been using as part of their skill to produce alpha are really market exposures or market betas.
But alpha of active performance often includes a lot of market exposures, that is market beta. Alpha, a return beyond a benchmarked return and risk, is often misused, AQR's Mr. Moskowitz said.
“Most academics would say that is not really active stock picking or not really securities selection. Those are just other forms of beta.”
“(A)lpha is often cloaked inside a broader portfolio that contains simple market exposures (or betas),” according to a paper earlier this year by co-authors from AQR: Clifford S. Asness, managing and founding principal and chief investment officer; Antti Ilmanen, principal; Ronen Israel, principal; and Mr. Moskowitz. “Since a single fee is charged for the portfolio, investors willing to pay high fees for true alpha end up paying exorbitant fees for traditional market beta. ... For example, hedge fund investors have often paid too much and accepted unfriendly terms for strategies that may contain some alpha but are clearly mixed in with a lot of market beta.”
Towers Watson's Mr. Stroud said, “We are big proponents of ... cost-efficient replication of some basic market exposures,” or betas. They are ideas that are embedded in actively managed portfolios that have “become well understood over time and commoditized over time.”
“Why go through, say, for example an active management vehicle or even a hedge-fund structure paying two and 20 — or a flat fee of 2% of assets under management and 20% of investment profits — for an underlying exposure that is really just a basic market exposure that you pretty much are going to put on and probably keep it there steady for a long time,” Mr. Stroud said.
Andrew Ang's work on factors inspired consultants at Towers Watson, Mr. Stroud said. Mr. Ang is the Ann F. Kaplan professor of business at the Columbia University Business School, New York.
In his paper, “Factor Investing,” published in 2013, Mr. Ang noted, “Many of these factors could be collected more cheaply by passive management.”
“We've worked with an external manger to structure something pretty cost effectively” using factors to improve expected return, said Mr. Stroud, who declined to name the manager.
Mr. Stroud said in his discussions with active mangers, they would present these factor concepts in their strategies: “And we say, "gee, is this really manager skill that we should be paying a full actively managed price for? Or this really a factor that they are allocating to that we can do elsewhere for kind of an index fund fee?'”
Some of these factors “are observable, but there's not necessarily an investment product that exists today,” Mr. Stroud said. “So our process is to engage with the investment management community ... to build a product that can be run cost efficiently.”
“Do you have to go through a hideously expensive actively managed structure” to get such exposure? Mr. Stroud asked. “The answer is often no and (the factors) can be accessed cheaply if you go about it the right way.”
“There is some role for active management, but it is very limited,” Mr. Stroud said. “We are not talking about an area where there is wide discretion for an active manager.”