By Claire Makin
When Denmark's $110 billion ATP fund closed its alpha
investment unit in 2013, a seismic tremor ran through the hedge
fund community. ATP had found that much of what it thought was
alpha, the rare skill-based return associated mainly with hedge
funds, was in fact derived from common return drivers, or
The institution's response was to roll the alpha unit into
its beta division to pursue more efficient ways of investing in
the same strategies. "There is very little pure alpha,"
concluded Henrik Gade Jepsen, ATP's chief investment officer,
at the Fiduciary Investors' Symposium in Amsterdam last
The same theme is sweeping through the investment world.
Alpha is being redefined as beta, and returns that were once
accessible only through expensive active mandates are being
replicated using rules-based processes that have come to be
known as smart beta (see 'Smart beta: at a glance', page
Smart beta indices are flooding onto the market. Banks and
asset managers are creating products based on them, and
competing to offer customised solutions to clients. Leading
consultants and influential institutions have endorsed smart
beta investing, while business schools are testing new theories
Consulting firm Towers Watson says that $32 billion of its
clients' assets are now allocated to smart beta strategies
across a range of asset classes. Clients made more than twice
as many new smart beta investments in 2013, about $11 billion,
as they did in 2012.
Research Affiliates, which provides the RAFI suite of
equity, low-volatility and bond indices, says that an estimated
$140 billion to $160 billion is now invested in smart beta
strategies. Morningstar, meanwhile, puts the estimate at twice
Crucially, increasing numbers of institutional investors are
starting to see smart beta as a substitute for active
management, whereas until recently they have viewed it more as
a passive substitute.
In April, the world's largest pension fund threw its weight
behind the trend. Japan's $1.2 trillion Government Pension
Investment Fund (GPIF) quietly revised its manager structure
and added a new category called 'Smart Beta active management -
an investment approach to effectively capture mid to long-term
excess returns through indexing strategies'.
According to GPIF's website, mandates were awarded to
Goldman Sachs Asset Management and Dimensional Fund
Coincidentally, Goldman Sachs Asset Management, which has $1
trillion under supervision, announced that it was launching an
Advanced Beta Strategies platform, and had agreed to buy
Westpeak Global Advisors, a leading US provider of customised
solutions for smart beta investing.
The new platform will have $30 billion in advanced beta
strategy assets under supervision, and combine elements of both
passive index and active beta-type strategies. A flexible,
dynamic approach is essential to staying ahead of a fast-moving
trend in changing markets, according to Armen Avanessians, head
of GSAM's quantitative business. "You need to be able to change
your rules. If they are static, you will become ossified," he
Another milestone in the onward march of smart beta is its move
beyond equities into fixed-income and commodities. Paris-based
Tobam, an advocate of equity smart beta with its
'anti-benchmark' philosophy, is the latest to launch a
fixed-income strategy, following Pimco, Research Affiliates,
Lombard Odier and others.
Tobam was launched in 2006 and has since sold stakes to US
pensions giant CalPERS, and Amundi, Europe's largest asset
manager. Amundi has just struck a deal with ERI Scientific
Beta, a smart beta platform that is aiming to set the standards
for the industry, and is part of France's academic EDHEC-Risk
Institute. ERI Scientific Beta, at the same time, has signed an
agreement for Morgan Stanley to replicate its indices.
In short, the 'search for alpha' of the early 2000s, which
led to the rise of institutional investment in hedge funds, has
become the 'search for better beta', as investors hunt for
uncorrelated sources of return to diversify their portfolios in
the post-2008 world.
The attraction is that investors can now access many of
these sources of return in model-driven formats at relatively
low cost. "What we see over time is that the benefits of
diversification can increasingly be optimised in a systematic
way," says Matthias Gaumann, who heads business development at
the smart beta solutions group of Lombard Odier Investment
Lombard Odier Investment Managers pioneered smart beta
strategies for fixed-income and commodities as well as equities
and now runs more than $5 billion across these strategies.
Some hedge fund strategies, including merger arbitrage and
convertible arbitrage, have been repackaged as smart beta
products and are being sold at a fraction of hedge fund fees.
Several exchange-traded funds are based on the S&P Merger
Arbitrage index, for instance. Carry and trend are also being
These advances have moved the goalposts for hedge funds. Towers
Watson research shows that 84% of monthly hedge fund returns
(based on the HFRI index) can be explained by common risk
factors and alternative betas, including carry and momentum
(see chart, above).
Towers Watson uses this information to assess manager skill,
and figure out appropriate fee terms. "It is almost impossible
to understand with any degree of certainty whether you are
getting skilled managers if you are not able to identify smart
beta in the market," says Damien Loveday, Towers Watson's
global head of hedge fund research.
Towers Watson has also created a portfolio of alternative
betas for delegated client assets. "Smart investors realise
that they can capture some of the interesting diversifying
premia that exist in the hedge fund market through smart beta
approaches," Loveday says.
This is not intended to replace hedge funds, however.
Loveday sees manager skill as an additional portfolio
diversifier, as is proved by the percentage of hedge fund
returns that still cannot be explained by betas.
The force of the smart beta trend has led critics to dismiss
it as product-led marketing. But that is to ignore the secular
trends lying beneath the hype.
Advances in risk analytics, computers that can handle 'big
data', and data sets that include the extreme events of 2008
have given index providers, banks and quant managers powerful
new tools with which to work.
This coincides with investor demand. Institutions have grown
disillusioned with active management, and the failure of the
return assumptions that they have relied on to allocate assets.
They are looking for a new paradigm.
Hence the interest in smart beta and factor investing, which
promises 'better' diversification by allocating to risk rather
than to capital (InvestHedge, February 2014).
Norway's $850 billion former petroleum fund, the Government
Pension Fund Global, brought academic theory into the real
world of big money following the financial crisis, when three
professors concluded that most of the fund's active manager
losses resulted from exposure to three risk factors: liquidity,
volatility and credit.
Norway then asked MSCI to assess whether factor indices were
suitable for very large portfolios, and as a result, adopted
smart beta benchmarks to reference its allocation.
In 2012, Denmark's largest public fund, PKA went a step
further and replaced its entire equity portfolio with an
allocation to a range of 17 risk premia. PKA's aim is to cut
its risk exposure to equity beta and free up more of the risk
budget to allocate elsewhere. PKA's equity portfolio is now
split 70/30 into traditional and alternative betas, which
include dividends, implied volatility, merger arbitrage, value
and liquidity event risk.
Last year, the UK's Pension Protection Fund switched its
equity benchmark to a minimum volatility index, as part of a
move from active management to smart beta. The PPF awarded its
first smart beta mandate in 2010, replacing an active
Many more influential European funds are adopting or
researching smart beta strategies, including PGGM, ABP, Robeco
and KLM in the Netherlands, Sweden's public funds, and France's
The ideas underlying this shift in focus are not new. Most
are based on quant strategies that predate the smart beta wave
by many years. Some long-established quant managers that have
avoided the smart beta label - such as AQR Capital Management -
are nonetheless creating products that could come under this
Advances in research and technology have moved the cutting
edge between theory and implementation much further forward in
recent years. Quant teams are identifying new factors across
asset classes, testing factors for persistence, analysing
correlations and devising ways to implement their findings.
This is the toughest part of the process. "It is easier to
define a risk factor than to invest in it," says Nicolas Just,
head of smart beta investments at Seeyond, the $21 billion
volatility and structured division of Paris-based Natixis Asset
Seeyond was set up in 2012 to manage institutional assets in
a risk framework. Just and his team are working on a second
generation of 'smart beta 2.0' strategies that aim to outsmart
the simpler first-generation index products. The new strategies
"combine risk factors efficiently in a smart way", according to
Just. This involves creating methodologies that can allocate
dynamically to factors, and rebalance when the underlying
biases violate certain rules.
Managers are also customising beta exposures to meet the
demands of clients to control specific risks. "Clients are
looking to diversify beta, but they are also looking to
implement their convictions," Lombard Odier Investment
Managers' Gaumann points out. Lombard Odier Investment Managers
is talking to large pension funds about ways to add specific
factors that match their beliefs or investment objectives.
Goldman Sachs Asset Management, through its advanced beta
platform, is also looking for persistent sources of return to
complement its clients' portfolios. Its work includes capturing
the risk premia that drive hedge fund returns and packaging
them in a more liquid way to add to Goldman Sachs Asset
Management's range of liquid alternative beta strategies.
The liquid alternatives market, in turn, is used by
increasing numbers of investors and providers including the
huge US defined contributions market. As competition heats up,
lines are blurring between passive indices and active
MSCI's new Multi-Factor indices, for instance, allow
investors to create their own customised index of factor
exposures and manage it actively with a tool called
How to define the increasingly complex strategies is one of
many hotly debated topics, along with almost every other aspect
of smart beta from its theoretical underpinnings to issues of
transparency, capacity and costs.
Clifford Asness, AQR's managing and founding principal,
deplores the claims that smart beta strategies are 'passive'
and give 'better market exposure'. Writing in the Financial
Analysts Journal earlier this year, he said: "To me, if you
deviate markedly from capitalisation weights, you are, by
definition, an active manager making bets."
Others agree. "Investors should realise that, without
exception, smart indices themselves represent active
strategies," said David Blitz, head of Robeco's quantitative
equity research team, in a recent research report.
Newer optimised strategies, such as minimum variance, have
highly complex methodologies that can add hidden risks, and
long/short methodologies using leverage and derivatives
underlie many new smart beta indices.
Even with full transparency and simpler strategies, it may
be unclear what is driving returns. Rob Arnott, chairman and
chief executive of Research Affiliates, which created the RAFI
fundamental index series in 2005, has pointed out that the
investment beliefs ostensibly underpinning many smart beta
strategies play little or no role in their outperformance.
In other words, they work, but not because they are
efficiently capturing a sound investment idea.
Others question how far institutions will be prepared to go
down the smart beta route, given that accessing a portfolio of
investable uncorrelated 'pure' factors is still a distant
At a seminar organised by Robeco in Rotterdam earlier this
year, Alfred Slager, professor of pension fund management at
Tilburg University's business school in the Netherlands,
presented the findings of a study into risk-factor
Institutions are implementing this approach in three ways,
said Slager. One is to leave their portfolio unchanged, but use
the information about risk exposures and diversification; the
second is to correct unwanted factor tilts; and the third is to
create a portfolio that is fully factor-optimised.
This type of portfolio is just a dream for most pension
funds, he said. Among other hurdles, the concept is difficult
to explain to trustees, and there is the question of who within
a fund's complex governance structure would make the
Some market participants worry about the sheer weight of
assets now tracking some of the indices, and the comcomitant
potential for conflicts this creates.
Mark Voermans, senior investment strategist at PGGM, voiced
his concerns at a roundtable discussion on smart beta and
factor investing in January, hosted by BNP Paribas Investment
Partners. Voermans pointed to the billions of dollars now
replicating MSCI's popular Minimum Volatility indices, which
announce their semi-annual changes nine days in advance.
"This means that any high-frequency trader or hedge fund
knows upfront what positions the replicating asset manager
needs to buy or sell. That is for sure too much information to
hand over to the market," Voermans said.
Where the hedge fund industry fits in the new framework is
closely linked to how investors are rethinking portfolio
construction and risk. As smart beta encroaches on hedge fund
alpha territory, hedge funds can go down several routes. They
can become providers of smart beta to the market, or they can
provide smarter alpha.
A third option is to use smart beta strategies in their
proprietary models, or take advantage of anomalies created by
the new products to gain a competitive edge, in which case they
are unlikely to share the information.
Along with other investors, hedge funds are of course heavy
users of factor-based ETFs and other smart beta products to
make tactical allocations.
Managers who choose to be suppliers of smart beta to the
market need to have a specific skill-set, as Goldman Sachs
Asset Management's Avanessians points out. He believes that the
most successful smart beta managers will combine rules-based
discipline with human judgement. "Not everyone can provide
insights from the alpha process, yet with the transparency and
ease of implementation of a passive process," he says.
Towers Watson's Loveday stresses that hedge funds remain a
valuable source of alpha. "People shouldn't see smart beta as a
substitute for investing in hedge funds because it's not. It
can capture some but not all of the risks, and comes with risks
of its own, that hedge funds might be better able to control,"
But Loveday notes that over the past five years, hedge funds
have had to adapt by allowing clients to dictate the vehicle
structure they want, their strategy focus and even terms. "This
will be the focus in future," he says.
Effectively this means that institutions are already
demanding smarter alpha.
Drago Indjic, an associate at London Business School's Hedge
Fund Research Centre, advocates holding managers' feet even
closer to the fire by requiring them to explain their sources
of return. "This is something we should start asking for. What
is your beta? There is no excuse," he says.
Funds of hedge funds are in a difficult position because
they mix hedge fund alpha and beta, and are no longer an
essential distribution channel for either, he adds. In his
view, the hedge fund industry has already lost the battle for
assets against behemoths such as BlackRock offering smart beta
But Avanessians believes that the discipline and
transparency of smart beta strategies will attract net inflows
to the alternative space. "By providing liquidity and
transparency, we will see more money diverted into strategies
that focus on absolute return," he asserts.
AQR took a similarly positive view in a 2008 paper entitled,
Is alpha just beta waiting to be discovered?, predicting that
hedge fund betas would form the low-cost, high-transparency
core of a hedge fund portfolio, surrounded by satellite
managers delivering true alpha.
This pool of alpha is likely to comprise highly
discretionary strategies such as equity and credit
event-driven, global macro, market-neutral and mispricing
opportunities that are not scaleable. "That is where investors
will be looking for the holy grail of alpha which cannot be
explained by beta," Indjic says.
'Super alpha' funds will also be compensated for other
qualities such as good decision-making, he believes.
Against this backdrop, it is difficult to see smart beta as
just another investment fad with a short shelf-life, like
portfolio insurance, portable alpha and 130/30 funds.
But just as smart beta will inevitably capture more of what
is now alpha, so hedge funds and other investors will come up
with new alpha ideas. As Towers Watson acknowledged in its
latest research report on smart beta: "Active managers have
been responsible for identifying many of the strategies that
are now being commoditised as beta."
But the smart beta bandwagon is on a roll, and hedge funds
will have to up their game to stay ahead. "The way we invest in
smart beta strategies today will be totally different two years
down the road. That's what makes it so exciting," Seeyond's
Smart beta: at a glance
So what exactly is smart beta?
Russell Investments defines smart beta as 'transparent,
rules-based investment strategies that are designed to provide
exposure to market segments, factors or concepts'.
Also known as 'active',' advanced', 'enhanced' or
'scientific' beta, and even 'smart factor risk allocation', it
is blurring the lines between active and passive as more
sources of return are captured by model-driven processes at
relatively low cost.
Public indices and exchange-traded funds are the most
popular way for investors to access smart beta strategies, but
as the trend gains traction, banks and quant managers are
competing to offer customised strategy indices and portfolio
solutions to clients.
Who invented it?
The underlying concept is far from new. US pension funds
were putting managers into equity 'style boxes' in the early
1980s. BARRA (now part of MSCI) popularised the earliest
multi-factor models and paved the way for the growth of the
The first products to be labelled 'smart beta' were created
in response to criticism about the risk concentrations in
traditional equity market cap-weighting. Underlying these
indices were exposures to systematic risk factors such as value
and small cap that are rewarded over time.
New-generation products aim to allow investors more choice
and greater control over specific risk factors, or 'better
betas' in the jargon. The smart beta industry has now
repackaged at least 20, including many that were once linked
exclusively with manager skill, or alpha.
Smart beta investing now stretches beyond equities and
across asset classes including fixed-income, commodities and
The catalyst was the 2008 financial crisis, and the main
drivers are advances in research and technology on the provider
side, coupled with institutional demand.
Investors are disappointed with active mandates; they are
searching for optimally constructed portfolios with better
control of risk. A smart beta approach has the potential to
meet these needs, because it takes account of diverse and
uncorrelated sources of return.
Institutions are starting to use these insights to change
their strategic benchmarks. Some are replacing passive
investments and active managers with smart beta strategies.
So is smart beta the end of hedge funds or just another
Neither. Hedge funds are still valued for their skill in
extracting alpha, although they will have to justify their fees
by focusing on return streams that cannot be accessed using
smart beta strategies. Alpha is being redefined, and it is also
As for being a fad, smart beta is still at the stage of
making promises, and there will be disappointment as investors
realise its current limitations. But it is a dynamic process,
not a static strategy, so despite the wishes of large parts of
the investment community, it will not simply go away.