How are approaches to combining smart beta strategies changing?

Richard Hannam: You will see far more use of multi-factor, the idea of trying to wrap two or three factors up in a single index because you are not putting your chips on red; you go for low volatility and it does not do well and you go for value and it does not perform well.

If you have some way of combining them – because they often do diversify; momentum and value tend to be negatively correlated – you can give yourself a slightly smoother path. 

The trouble is, as you start to do that it becomes more complex, and we always think in this space complexity is a bad thing. The more decisions you make, the more it becomes like an active process. 

Ronan Kearney: The more factors you put in, surely the closer you get to just buying the market, you tend to lose the benefits of focus. What will make you excess gains, rather than just taking what is available, is focus on a few particular areas you believe will do better. 

What I am interested in, though, is what pension funds are buying in order to access smart beta. What are they physically buying, right now?

We always think in this space complexity is a bad thing. The more decisions you make, the more it becomes like an active process

Richard Hannam, SSGA

Hannam: Well, they might be buying a fund, or I suspect some of them will be doing it via swaps or having separately managed accounts that are a bit more bespoke. However, in most cases it is index managers working out what appear to be the popular index strategies from the main index providers, creating funds and watching the money flow.  

Simeon Willis: That is really interesting and the point you make about several different factors [when] combined converging to the index. Really, the ‘smart’ part of smart beta is the selection of factors, because if you are an average investor selecting some factors, you are going to choose an average across all of them and deliver market returns. 

Smart beta is really just a recipe allowing you to create your own success or failure, and it is down to you as the decision-maker. So this is a governance point: it has moved the decision from an active fund manager to either the consultant, CIO, or trustee board who has selected the factors.

Hannam: Absolutely. However, you are also in an uncomfortable position if it goes wrong, because if you buy an active manager and they do badly, you will say, ‘Well, we picked the wrong one, so we will fire that one and find someone else that has a good track record.’ If you had taken that in-house and you are the CIO, the board owns that decision and the responsibility.

It can be an uncomfortable place to be if, two years down the road, it is looking poor, relative to where you might have been.

Maxine Kelly: How do consultants feel about that responsibility? If they are playing a larger role in helping schemes make those choices, do they feel burdened by that?

Alex Koriath: I think you need to do your homework in terms of having a clear view of how the different factor exposures are valued, and express a view on that. 

I guess there is delineation between implemented consulting or fiduciary management and traditional advisory. I believe that, when you actually look at the portfolios where you can find these products, you find them much more in fiduciary or implemented portfolios where the consultant makes the decision exactly for the reason you laid out – a number of trustee boards might not feel comfortable making factor-valuation calls.  

What is not readily available is a benchmark for how you implement an alternative beta strategy. How do you buy a factor most efficiently? How do you implement a value bias? 

Alex Koriath, Cambridge Associates

Kelly: Do you think it is less relevant whether one strategy is better than another, and it is more about whether the risk factors are complementary to everything else in a pension scheme’s portfolio?

Hannam: We did some recent research for one of our clients who has been doing this for a while and our view was: if you looked at the different indices – if you looked at, say, value – it did not really matter which one you picked, they were all correlated by 0.95 or above. The decision was, am I comfortable having that in the portfolio and over what period? 

Koriath: Agree, and it goes back to your earlier question: how do you benchmark such an allocation? You might be able to benchmark risk, return, compare it versus other different variations of smart beta; compare the current valuation of a low-volatility strategy versus the valuation metrics of a market cap index. 

However, what is not readily available is a benchmark for how you implement an alternative beta strategy. How do you buy a factor most efficiently? How do you implement a value bias? What is an implementation benchmark?  

Willis: There are two approaches: you either have a balance of different factors – which gives you a pretty diversified exposure and it is not really going to massively outperform or massively underperform – then you have a higher conviction [approach] that focuses on one or perhaps a couple of factors and it is a bit more concentrated.

That has scope to deliver substantial outperformance, but implicitly would have the scope to deliver substantial underperformance as well, depending on whether you were right. If you are going to do something meaningful with smart beta, that is the risk you are taking.

Stephen Miles: On the accountability point, that is still not clear enough. We surveyed asset managers and there was no consensus. So who is responsible for a smart beta strategy? Who is in the driving seat? You might be asking an index provider or an active manager to pick the factors now, but what happens if markets change in the future?

Markets are complex systems; they are not static and they do not behave like the 30-year back test. 

What happens, for example, when the correlations between two factors change or the characteristics of the factors themselves change? That is a concern I have: making this clear to the asset owner.

The consultant is usually not in the driving seat for a multi-factor index; it might be the index manager or the asset manager, but often they too are not signing up to ongoing management and changing of factors over time, since the fees are so low.