Investment performance might ebb and flow like the tide, but fees are as certain as death and taxes.
This truth – enabled by advances in data processing – has underpinned the rise of cheaper ways of investing over the past decade.
We have seen the rise of index tracking funds, exchange traded funds (ETFs), passive investing and smart beta in the lexicon of money managers and advisers.
But the rise of smart beta, passive investing and ETFs present a myriad of opportunities and risks.
Organising the lexicon
All too often ETFs, index tracking funds, passive investing and smart beta are lumped together.
While there is a common thread found in lower costs by simplification of the analysis and research function, there’s value in clarifying what each of these approaches involve.
Active investing involves a portfolio manager researching, analysing and selecting and adjusting investments with the objective of generating alpha.
Passive investing generally tracks an index and invests based on market cap – giving the investor returns which match the index such as the ASX200 or Dow Jones Industrial Index.
ETFs are exactly that – managed investment schemes and unit trusts which can be traded into and out of using existing market infrastructure such as the Australian Securities Exchange (ASX).
While many ETFs are passive or index tracking, more conventional actively managed funds can also be traded on an exchange in a similar fashion. As of January 2018, assets held in ETFs globally were about $5 trillion.
Smart beta is a form of investment management that adopts components of passive and active attributes.
A baseline such as an index trace (beta) is the starting point, which is then enhanced (the ‘smart’ bit) to account for certain factors which are considered to be important in determining performance, which is better that plain old beta.
These factors are derived from its easily replicated, transparent, rules based and cost-effective approach within a wide investment universe.
Smart beta aims to use certain combination of ‘factors’ such as size, value (including dividend yield), volatility and momentum to pick the stock with the aim of outperforming the market.
Smart beta positions itself as an investment method which hopes to deliver alpha, or performance above the benchmark at a lower cost (and thereby a reduced fee).
ETFs have saved investors many billions of dollars both directly and indirectly, through the price pressures they have put on traditional asset managers, although some would say there has been a strategic trade off in the portfolio construction process of investors’ portfolios.
Lower Fees Are a Good Thing
On face value, it’s difficult to see developments which reduce the fees paid by Australians from their retirement savings as anything but a good thing, especially where net investment performance is pegged to the mean.
Over the past decade, we’ve seen the fees paid by superannuation funds being driven down close to the psychological 1 per cent barrier.
It’s probably important to also note that in absolute terms the fees paid continue to increase. The 2015-16 year saw $7.8 billion in investment management fees paid from the superannuation system.
It’s important that Australians benefit from significant alpha, or value added by the managers of their investments.
Scale efficiency is an absolute necessity, but the prospect of lower cost diversified exposure to markets might help in pushing below 1 per cent. Low cost investment strategies might have a significant role to play in achieving this.
The role of reducing the research and analysis costs and fees has become an increasingly important factor for superannuation funds and investment managers to consider since the amendment of RG97 and the standardised disclosure of indirect fees and costs.
Regulatory reform of similar effect has also come about in the European Union (MIFUD2).
An extra layer of complexity has been added for the super funds to provide the breakdown of the fees and costs (mainly) involved with the investment products.
Self-manage in house?
The combined effect of asset-based fee structures and increasing scale has been one factor pushing asset owners to internalise the investment management function in recent years.
This has taken the form of large Australian Prudential Regulation Authority (APRA) regulated institutions bringing management of some portfolios in house, and similarly large account holders establishing self-managed superannuation funds.
The emergence of investment options such as ETFs and smart beta, combined with availability of software, could potentially provide some options for super funds when considering internalisation of the investment functions as this might potentially reduce their investment fees and inversely the admin fees charged towards members.
Some of the reasons for funds to consider the option of internalising and adopting smart beta to potentially enhance retirement savings could be:
If the fund is keen to move away from too many active mangers operating with the same mandate, which might result in index-like returns by taking on the full advantage of the long-term results of factor investing;
If the fund wants to change the strategy around managing assets i.e. lowering the volatility or capturing specific returns aligned with portfolio goals; and
Access to investment strategies that lie in between active and traditional index strategies, with the potential to outperform cap-weighted indexes at a lower cost than active management.
Smart ESG Beta
One other value proposition for funds considering the adoption of smart beta strategies is their integration with other product offerings in such a way that can enhance the retirement savings.
One such combination is incorporating responsible investment [environmental, social and governance (ESG)] with smart beta factors such as good value and low volatility assets.
In Australia, some of the big pension funds and investors are incorporating ESG screening as part of their investment strategies.
One challenge which a fund might have to consider while trying to combine or apply smart beta strategies with ESG is availability of data from companies, as generally it’s not required of them to disclose ESG matters.
Even if smart beta does not integrate with the fund’s strategy, one of the options the fund might consider is creating a product which has a component of ESG and smart beta and allows the member to make the investment choice or use trusted investment houses such as BlackRock or Vanguard to provide this option as an investment choice.
Buyer Beware
Some of the risks or concerns with integrating smart beta strategies focus on the understanding of the factors and the application of those factors.
When you use various factors and combinations and run a fair number of data tests, some strategies will appear to outperform.
Research conducted by Kewei Hou and Lu Zang of Ohio State University and Che Xue of the University of Cincinnati identified 447 stock market anomalies in the academic literature.
When they tried to replicate the scenarios, it highlighted that nearly two-thirds lacked statistical significance; no more conservative approach, the failure rate rises to 85 per cent.
One of the reasons for not being able to replicate the anomalies could be because of few scenarios depending on the data and certain factors could offset certain elements. For example, higher returns compensate for some form of risk.
Another element is momentum. Sometimes investors might be slow to identify the best performing stock and once identified, depending on how quickly investors react, ‘crowding’ could impact the outcome.
Traditionally a fund manager would evaluate a company based on quality, tail, volatility and risk before picking a stock.
But in today’s scenario where there is an increased use of algorithmic trading programs it changes the dynamics with increased speed, scale and complexity.
Whilst there are great benefits, there is also risk that with all the complex systems (for a multifactor based scenario) how the program will interact is a bit unpredictable.
The adverse effect of this might be if more securities are traded faster, accidents might be bigger and more sudden.
Is there an off-the-self solution to address the issues highlighted above?
The intuitive response is ‘no’. But it might worth a shot carrying out a litmus test to see if the new disruptor i.e. adoption of smart beta can support or aid in addressing any of the issues under discussion.
When we see lower cost with good returns, it does sound like a good enough unique selling proposition for super funds. But if you were to ask an investment manager, the short answer will be ‘it depends’.
Though smart beta has been around for a decade, its multi factor based strategies are yet to prove to the investment managers that the results will be as predictable over a full market cycle like ETFs.
One of the most interesting aspects of the rise of low cost investment strategies is the potential that it presents for active investment managers to create alpha by exploiting the biases which are programmed into the automated processes of index tracking or smart factor based investing.
Disrupting Alpha?
Recently, a few of the large super funds in Australia (such as QSuper and Australian Super) have set the ball rolling with the internalisation of investment teams and adopting smart beta as part of their investment strategies.
The question is if it will work for every other fund.
Though smart beta has shown potential, at this point in time it is in no way close to replacing alpha or active investment managers. The question for the fund and investment managers is: Will smart beta integrate with their strategies and help grow the retirement savings for their members?
Shyam Rajagopal is a senior consultant at QMV Super Solutions.
