For institutional investors, smart beta strategies — whether implemented actively or passively — lead to significant areas of ambiguity related to fiduciary responsibility.
Where does accountability reside for investment outcomes in alternatively weighted equity risk premium factor approaches? Who bears fiduciary responsibility?
Many institutional investors have coalesced around the idea that smart beta strategies represent active investment ideas. Irrespective of the approach, every smart beta investment idea is purposefully weighted in a way that is significantly different from the market, which like it or not is capitalization weighted.
Decisions to deviate, regardless of method or purpose, are active decisions.
When it comes to smart beta investing, there is also a strong temptation to assume that strategies based on risk premium factors, once defined, are somehow generic or self-evidently transparent.
Definitions can be highly subjective, different depending on the provider, and often quite complex as evidenced by construction methodologies and disparate risk and return outcomes for strategies that sound identical on the surface. For example, one hears frequent reference to equity investors trying to capture a “low volatility premium.” But this might not be as straight forward as it sounds. The returns to the S&P Low Volatility index and the MSCI USA Minimum Volatility index — two low-risk indexes that sound very similar on the surface — exhibited a nearly five-percentage-point performance differential for the year ended June 30, resulting from non-trivial differences in the way the index providers define “risk,” adjust for undesired exposures and build the indexes once a strategy is characterized as beta. While we are defining the strategies as active and non-generic, the implementation is often passive.
There are many examples in the index-replication world of investment strategies being implemented passively, as the replicators dutifully track an underlying index but have no responsibility to question its assumptions or the logic of the index's construction. The easiest and most familiar example of this is the replication of the S&P 500. This represents passive investing both in the underlying investment strategy (as the S&P 500 is a representation of the capitalization-weighted market), as well as with respect to implementation.
The rise in popularity of smart beta strategies can extend this replication practice to an underlying investment strategy that takes active risk, but is implemented passively by an index replicator whose mission is to mimic the performance of the underlying smart beta index.
An active strategy with passive implementation leads to a significant area of ambiguity in the smart beta space, as well as significant potential for concerns as to where the accountability for investment outcomes resides.
The index replicator is evaluated solely on the ability to faithfully mimic the underlying index. But who bears responsibility for the investment ideas underlying the index itself? In these examples, there is one entity — often not an investment adviser with a fiduciary responsibility to investors, rather an index provider — that creates the investment strategy in the form of a published index.
The separation of a strategy from its implementation leads to significant ambiguity as to who, exactly, is on the hook from a fiduciary perspective. The implication might not be appreciated by investors who think of risk premium factor investing as a completely generic and passive activity.
Uninformed implementation of a complex investment idea might not ultimately serve institutional investors well, even at very low fees. Smart beta strategies provide an attractive way for investors to access the equity market more efficiently, but the popularity of these inherently active strategies has obscured who bears fiduciary responsibility for real investment outcomes.
Jeremy Baskin is Orinda, Calif.-based global CEO and global chief investment officer at Rosenberg Equities, a unit within AXA Investment Managers. He is also a member of the AXA IM management board and executive committee.
