In the third part of a four-part discussion, Aon Hewitt's Tim Giles, Axa IM's Madeline Forrester, Nick Motson from Cass Business School, LGIM's Simon Midgen, the PPF's John St. Hill and Russell Indexes' Jamie Forbes discuss smart beta fees.
Tim Giles: They should be passive [fees] plus a little bit and generally if it is just a factor-driven process, a benchmark-driven process, that is what we would expect – trustees do not expect to pay much more for it. You have got to take on board that the total cost includes the rebalancing effects, the expenses you are going to incur from regular transactions, alongside management costs.
Setting up a strategy that would bid away all the profits you have made through transaction costs would be pointless
Tim Giles, Aon Hewitt
Madeline Forrester: How much are people looking at total costs, with fees and the cost of implementation of each of the strategies alongside each other?
Giles: If we were putting forward a manager we would be considering the total costs. Clearly the management fees are the headline number, but equally setting up a strategy that would bid away all the profits you have made through transaction costs would be pointless.
Simon Midgen: From our perspective as an implementer of index strategies, if you are not careful then all the additional turnover these indices have – and for some of them it is very significant – will be eaten up in costs, so you are losing a lot of the benefit of the strategy you are expecting to provide. Probably the most important job of any index implementer is to figure out how to minimise those costs.
Jamie Forbes: That goes back to where we might see areas of innovation; the index provider and the implementer getting smarter about managing the costs of the turnover, how frequently that index is rebalanced and capacity issues that should be addressed, maybe within the rules of the index to help enable them to be implemented more efficiently.
Forrester: Efficient implementation is key, it has to be. And leaving a minimal footprint when you trade.
Forbes: Because otherwise it can undo all of the performance shown in the backtests. None of those backtests have transaction costs calculated in there, they cannot. So there has to be reasonable estimates of what those are going to be, and a reasonable understanding that those are being mitigated and managed through the implementation.
Nick Motson: You all talk about the providers and [how fees] should be nearly as low as passive, but should the innovators be paid some sort of rent for coming up with the innovation? They have all tried to protect themselves – you cannot use the words ‘fundamental indexing’, [asset manager] TOBAM has trademarked ‘anti-benchmark’ and I think Lyxor have ‘equal risk contribution’ – they all protect the names but the formulae are in papers and journals; anybody can copy them and start their own fund and do it. So is it just about fees? Should the innovators be paid something so that they continue to innovate? It is like downloading music, is it not?
Forrester:
Clients want us to be very open about circumstances when the rules may not work and to innovate, if necessary
Madeline Forrester, Axa IM
But is that not the point, it is about whether you are prepared to pay the fees for innovation. So if you are going for an active strategy, clients want us to be very open about circumstances when the rules may not work and to innovate, if necessary, going forward. Some clients like that and some want a more traditional rules-based approach. They may think you got it right once but they do not necessarily want you to continue to innovate. And I think when people sit back and say, ‘What are my beliefs?’ one of the questions they need to ask is, ‘Do I believe that over time markets change?’, albeit maybe in iceberg-like ways and very slowly. Actually some organisations and some individuals are better at predicting that change than others. If you do, then paying a premium for innovation is probably worthwhile. If you do not believe that is possible, then it is not.
Giles: You have got two parts there, have you not? You have got to have a firm that can skillfully manage the factors in a steady state, and then a firm that can innovate and market-time around it.
Forrester: Or at least to have that dialogue, and you would not do it very often.
Giles: What we tend to see if a process is winning and working – and that creates the track record – something that then comes and changes the process will be a cause for concern, because then you do not know whether the manager has the skill to deliver the changed process based on past experience.
Forrester: It is about having an open and honest dialogue about ‘this is why we are underperforming; because this product was selected on this basis and you can now stick with it, or we can debate what we might want to tweak’. I am not suggesting you would change something with it without this discussion. Transparency is key to this, but at the same time we probably do not want to tie ourselves in now, to be static forever.