Smarter alpha, better beta

June 09, 2014  

Smart beta has taken the investment world by storm. Hedge funds can exploit the trend, but many will fall victim to it

By Claire Makin

  © Niki Natarajan
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 betas.

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 October.

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 20).

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 and applications.

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 that figure.

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 Advisors.

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.

  Armen Avanessians
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 says.

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 Managers.

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 implemented systematically.

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).

  Damien Loveday
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 manager.

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 FRR.

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 heading.

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.

  Nicolas Just
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 Management.

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 management.

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 IndexMetrics.

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 goal.

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 investing.

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 decisions.

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," he says.

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 products.

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 Just says.

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 industry.

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 currencies.

Why now?
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 fad?
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 being repriced.

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.

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