Abnormal Returns is on a bit of a respite this week. That does not mean that we are content-free. As we have done in previous years we asked a panel of highly respected independent finance bloggers a series of (hopefully) provocative questions. Below you can see the blogger’s name, blog name and Twitter/StockTwits handle. We hope you enjoy these posts as much as we do. Feel free to jump in the comments with your own answers to the questions.
Question: The ‘smart beta’ or factor-investing bubble seems to be in full bloom. Is ‘smart beta’ simply the new active investing? If so, what happens to the entire fund industry which was built on the high fees associated with active management? (Answers in no particular order.)
I’m honestly not terribly impressed with Smart Beta. It’s mostly driven by marketing pitches. To my mind, it’s another form of chasing return. To the extent that any of these strategies work, it tends to be small and fleeting. (Make no mistake, I believe some are real.) The bottom line is that straight vanilla indexing is probably better for most investors, and simply buying and holding great stocks is even better than that.
Active investing is never going away. Smart beta has created its own lane as Active-lite, and I believe it will bleed into more active management over time. The factor edge is will erode with increased popularity, and/or the AUM will demand more products. Passive investing introduced the concept of “closet indexers”. I can imagine in the future a subset of funds will call themselves smart beta while taking license to be more active, without the stigma of being labeled fully discretionary. Meet “closet actives”.
I happened to write a recent post about smart beta investing. Some good insights in the comments too: https://humblestudentofthemarkets.com/2016/03/14/the-dirty-little-secrets-behind-smart-beta/
The new active investing is using low/no cost ETF’s and other structured products to create hedge fund-like products at retail investor-type fees. Fee compression is a secular story in investment management.
Active fees will continue to compress until these funds become more competitive with the lower-cost indexes – smart beta or vanilla. Then we’ll have ourselves a ball game.
I think we’ve reached the point now where talking in terms of active and passive is no longer helpful. I don’t like the term smart beta — I prefer alternative beta or factor investing — but, whatever you call it, there’s certainly a place for it alongside conventional indexing. It’s definitely not the panacea that some make it out to be, and not everyone will want to take on the additional risk. But for me it does make sense to have some exposure to different risk premiums in a broadly diversified portfolio.
Yes, the rise of alternative beta has big implications for the active industry, which will undoubtedly need to reduce its fees much further. I hope, too, that fund management companies will be a little more honest people about how any outperformance has been achieved. In other words, have managers genuinely shown skill? Or have they simply tilted their portfolios to factors such as size and value that are known to deliver higher returns over the long term?
Smart beta and factor investing are the newest versions of high(er) fee active management promising the fairy tale of “market beating” returns in exchange for higher fees and usually delivering lower returns (after taxes and fees).
Smart beta is typically closet-indexing with an element of diluted active management attached. So that isn’t new — that’s the active management industry. However, “smart beta” is being delivered cheaper and more tax-efficiently via the ETF vehicle — which is great news! So from a strategy perspective there really isn’t anything new, but the ETF wrapper is certainly a welcome addition. The danger with smart beta is the same danger with all active strategies: you rarely understand what you are buying. For example, an active “value” fund can mean many things. We have a piece on how to pick smart beta funds, which helps investors think through their decision. In that piece we reverse engineer out how much you are actually paying for the active component of many smart beta products. We find that the “active” piece that investors get in smart beta funds is typically low and expensive. In fact, many closet-indexing smart beta funds are implicitly charging a lot for the “active risk” they think they are buying. Often investors can get a better deal by coupling a highly active fund at reasonable costs with a low cost passive index. Bottom line: know what you’re buying and how it works in your clients’ portfolios.
Factor investing is taking on a lot of the characteristics of active management, especially performance chasing by investors, advisors, and all kinds of intermediaries who are proclaiming their expertise in putting these things together in portfolios. That chasing will destroy value there too. Also, there’s a lot of data mining leading to “the illusion of superiority” (Arnott’s phrase); many of the vehicles look good on paper but fizzle in the real world. Nevertheless, their popularity will add to the pressure on active management firms that started with traditional passive gaining share. I expect significant industry disruption.
Smart beta is a form of enhanced indexing. It is not active management. As in the quant quake in August 2007, “smart beta” will have its own episode of failure when too much money pursues it. It will be uglier due to the lack of human intervention. Active management will continue to shrink, but those who do it will have better opportunities. Fees will be under pressure, but less so than most imagine.
The best kind of active investing is decades old, finding values that the market is neglecting. It often suggests holdings that are the opposite of the current favorites.
It’s tempting to argue that traditional active investing is dead, but I think only high-fee active management is dead (even if high-fee active managers don’t all know it yet). However, the biggest mutual funds in terms of AUM include some traditional active managers — they also charge much lower fees and, largely as a consequence, have solid records. I expect these to survive. That said, the research seems clear to me that cap-weighted indexing is less efficient over the longer-term than factor investing, so I see factor investing as having a bright future even if it isn’t nearly as “new and improved” as its marketers want to suggest.
Smart beta or factor investing has been around for decades, it’s only recently became this mega buzz word. The fact that there are more smart beta strategies than stocks in the S&P 500 shows that the market has quickly become over saturated. I’m a big believer in factor investing and I think low cost access is an amazing development for serious investors. The problem I foresee is that people will chase the hot strategy the way they chased stocks or star mutual fund managers.
Fees will continue to decline everywhere, which makes it a wonderful time to be an investor!
ETFs are one of the greatest investment product inventions ever, but the unintended consequence of their convenience is that it’s tempting to trade them and continually switch to different strategies or funds. As I said in a recent post, I think ETF-picking is becoming the new form of stock-picking and smart beta ETFs will have a big hand in that as investors rush into and out of the best and worst performing factors. Common sense would dictate the the current crop of closet index mutual funds should become mostly extinct, but the world doesn’t run on common sense. The world runs on incentives and fund companies are incentivized to offer higher fee products to juice their profits. Eventually ETFs will overtake mutual funds, but I’m guessing it will take longer than most people think as fund firms will have to be dragged kicking and screaming into this lower fee world.
Yes, Smart Beta is fancy MBA speak for high fees. People are getting smarter and learning to just plow money into an index fund and be passive with low fees.
The ‘smart beta’ or factor-investing bubble seems to be in full bloom. Is ‘smart beta’ simply the new active investing? If so, what happens to the entire fund industry built on the high fees associated with active management?
Smart beta is the commodification of historically proven factors. Commodities must be widely available. Smart Beta funds and ETFs have been constructed to accommodate scale (lots of assets under management). The best active management isn’t built with scale in mind—active management should be about alpha, not scale. Science fiction master William Gibson wrote in his book Pattern Recognition that “commodification will soon follow identification.” When new “factors” are identified, they will be quickly built into scale-able ETFs—but that won’t mean the factor itself is rendered useless. Focus on more pure expressions of factors, not strategies with hundreds of holdings and market cap weighting schemes.
In another passage, also from Pattern Recognition, Gibson is talking about clothes, but he could be talking about Smart Beta ETFs:
This stuff is simulacra of simulacra of simulacra. A diluted tincture of Ralph Lauren, who had himself diluted the glory days of Brooks Brothers, who themselves had stepped on the product of Jermyn Street and Savile Row, flavoring their ready-to-wear with liberal lashings of polo knit and regimental stripes. But Tommy surely is the null point, the black hole. There must be some Tommy Hilfiger event horizon, beyond which it is impossible to be more derivative, more removed from the source, more devoid of soul.
Many asset management firms are going to move towards rules-based management strategies for ETFs and likely cannibalize their own traditional products in an attempt to retain market share. More informed consumers of financial products are going to be more sensitive after decades of blissful ignorance. As we saw in ’08-’09, when withdrawals hit traditional products, they don’t come back. Instead those assets move into some kind of lower cost product. The future of asset management is in ETF portfolios, be they smart beta or tactical or strategic allocation strategies, or some combination of all three. Stock picking for 1%+ is a dying business.
In my opinion, smart beta does not equal active investing. Active investors pick themes that tend to change over time given their research and fundamental market outlook. Smart beta indexes stay with a specific niche and their holdings typically don’t rotate as often as an active manager. As completion becomes fiercer, we are likely to see a trend of lower fees in smart beta indexes to further draw out assets from expensive mutual funds.
I do feel that the fund industry will continue to feel the fee pressure as flows continue to move in the direction of lower fee solutions, but I don’t believe smart beta is the panacea many are hoping it will be. Smart beta may be the new active investing, but that may because it is similarly overpriced relative to what it will provide.
That said, similar to active management, all smart beta solutions are not the same. The seemingly unlimited demand for smart beta products has largely been met by quantity, rather than quality. Michael Batnick recently pointed out there are more smart beta funds than stocks in the S&P 500. I wonder if the generally disappointing performance of these new products is a result of their demand which has effectively removed the historical benefit.
Perhaps analysis of the persistence of a smart beta fund’s factor may turn out to be the ‘manager due diligence’ equivalent of the smart beta world.
Financial markets tend to constantly overshoot to the upside and the downside. The reason behind that behavior is that investors constantly underreact to new information; then they panic (because of fear of missing out or fear of losing) and overreact. The increasing popularity of Smart Beta Strategies is likely to create even more excesses in an increasingly correlated market.
Thanks to everyone for their participation. You can also check out yesterday’s edition as well. Stay tuned for another question tomorrow.