Smart Beta versus Active Quant Management – Accountability Matters

Factor investing as an investment approach has grown rapidly in appeal in the past few years. In parallel, exchange traded funds (ETFs) have gained popularity as a low-cost investment vehicle for accessing professionally managed passive strategies. The marriage of factor investing, and ETFs gave birth to the “Smart Beta” fund category.

To meet the growing demand for Smart Beta ETFs, index providers have raced to create indices which represent an array of popular factors such as value, momentum, quality, minimum volatility and size. A Financial Times article in January 2018² claimed there are now 70 times more stock market indices than publicly traded stocks, and factor indices contribute meaningfully to the recent growth.

Choice aside, Smart Beta’s popularity comes down to the cost and ease of access. Smart Beta ETFs are typically cheaper than other active strategies because (at face value):

• Factors are now well understood and index representations of them are readily available. Index providers will calculate these for a relatively small cost - or in some cases free.
• Implementation of a strategy that exploits these factors can be made relatively simple and mechanical by just tracking a factor index.

As the merits of factor investing have gained traction, asset allocators have begun to use Smart Beta ETFs as strategic and tactical building blocks in asset allocation. The liquidity and availability of ETFs has great appeal in this domain, as does the reduced effort to invest in a listed ETF compared to onboarding a new active investment manager – particularly for short- or medium-term exposures.

In a typical Smart Beta ETF, the manager (or ETF provider) will passively track an index that is ultimately created and calculated by an unrelated index vendor; and this is where the “beta” tag arose. However, unlike market beta, which is relatively unambiguous, factor beta is anything but.

In the case of traditional market beta there is not much room for disagreement about what represents the market (the cap-weighted portfolio of assets). But when it comes to a factor, there is no universally agreed definition. For example, even though it is widely agreed that the Value factor represents owning cheap stocks (relative to their assumed fundamental value) and avoiding expensive stocks, there are many degrees of freedom in arriving at a precise definition of an investment strategy or index to capture the factor reward.

Fig 1 shows the median and range of returns over various time horizons (leading up to August 2018) for a range of commonly used US large cap market indices. Despite the differences in methodology, number of stocks, etc., there is little variation in the outcome – you get roughly the market return whichever index, index fund or ETF you invest.

In contrast, Fig 2 shows the return outcomes over the same time horizons for a sample of 17 ETFs that provide cheap access to the Value factor within US large cap equities. There is a total of 14 different indices from 11 different index vendors used by these 17 ETFs. What is even more notable is that the return outcomes are surprisingly varied, despite them all aiming to capture the reward from the same factor in the same market segment.

The specific Smart Beta fund an investor chooses has a significant bearing on the return outcome, so this decision warrants a high degree of scrutiny.

When you hire a passive manager (or invest in an ETF that tracks a factor index), the manager’s one and only goal is to deliver the return for the index that you both agreed the passive manager will track. This index will have been created and is maintained by a third party (index vendor), often with the discretion to change the methodology in future.

The Smart Beta manager needn't believe in the factor's ability to produce long term excess returns, nor agree with the assumptions and decisions that were made to derive the factor index methodology. In many cases, the manager will have no input into the methodology changes to the underlying index.

The manager needn't lose sleep if the factor index he is tracking starts to underperform – so long as he is effectively tracking the index, there is no strong incentive to do any better because that isn't what you hired (or paid) them to do.

There is a strong use case for Smart Beta ETFs if an investor:

• after rigorous analysis and due diligence has arrived at the conclusion that they want to allocate to a specific factor,
• finds a Smart Beta fund or ETF whose underlying index methodology is precisely aligned with the investor’s own definition of the factor,
• is comfortable with the potential future variations that the index provider may make to the factor index methodology.

If all these criteria are met, the investor’s most rational goal should be to seek the cheapest implementation of this strategy – and that is what Smart Beta ETFs offer. In markets where there is a wide selection of Smart Beta funds, this is a viable alternative, but it is particularly challenging to find a fund with a perfectly aligned methodology when options are limited (Asia and emerging markets fall into this category).

While the fees for Smart Beta are certainly appealing as they converge towards passive fee levels, it is crucial to acknowledge that they are very much active strategies. The ETF manager and the underlying index provider are certainly making active decisions that define how the fund will be managed. However, they do not assume the long-term accountability for these decisions, nor the responsibility of continually evolving and assessing them over time. Ownership of these active decisions, therefore, rests entirely with the investors deciding to invest in the fund. This is essentially why they are cheaper.

By contrast, an active quant manager, while likely charging more than Smart Beta ETFs for what may appear to be a similar strategy, will have much clearer alignment with client outcomes. An active quant manager will be critical of his own historical analysis and thoughtful in all active decisions within a strategy, in a way that a Smart Beta fund will not, simply because they remain fully accountable for the future outcome.

The implementation of any asset allocation strategy plays a crucial role in the final outcome achieved, and there is significant value in ensuring an alignment of incentives with your investment manager and their ongoing active decision-making efforts. Smart Beta’s popularity has shone a light on factor investing and its many merits, but implementation through actively managed factor strategies offers the incremental advantage of accountability.