Smart beta’s next phase, which Moody’s calls “smart beta 2.0,” will be more research intensive. Moreover, Moody’s said, smart beta funds will likely compete directly with traditional mutual funds, given that future smart beta strategies will not only use multiple factors, but will also incorporate decision-making processes to determine and actively adjust a fund’s level of exposure to different factors and betas.
More from the report over at the Financial Times:
“In a sense, smart beta 2.0 will evolve into a more disciplined and cheaper form of active management — that is, it will attempt to achieve the goals of traditional active managers, but at a lower cost and with more consistency in terms of adhering to a set of investing rules,” Moody’s wrote in the report.
I think the previous quotes hits two big points: discipline and costs. Michael Batnick at the Irrelevant Investor hits on the importance of consistency for an investment process:
When considering active strategies, it’s important for us that we’re not relying on anyone’s intuition, expertise, or mental or emotional well being. We don’t want our PMs speaking with management, doing channel checks or backing out the cash. We want them to follow their models with as little interference as humanly possible.
On the subject of costs there is little doubt that ETFs and indexing more broadly have put the hurt on traditional mutual funds. Something like ‘smart beta 2.0’ takes direct aim at the cash cow of the incumbent money managers: actively managed equity funds. As Ben Carlson at A Wealth of Common Sense writes in his book:
In the future, simple portfolios will be extremely low cost while factor tilts will be cheaper than ever through a combination of competition and scale. Smart beta ETFs are already starting to turn a form of systematic active investing into this same type of process.
It should not be surprising that incumbent managers are snapping up smaller investment firms with quantitative expertise. They can read the writing on the wall. What it means for investors will be more choices when it comes to active and semi-active strategies. Which in theory is great. Especially when you take into account the potential tax advantages of using an ETF wrapper versus an open-end mutual fund.
However with additional choice comes the opportunity to make mistakes. For most investors following a simple investment strategy is difficult enough. Adding in the potential for factor underperformance and shifting risk profiles will only complicate matters. Investors should welcome ‘smart beta 2.0.’ It is certainly better than high cost, inconsistent alternatives. But in the end the ETF tool is only as good as its end user.