The thinking behind the approach is to use alternative indices from the traditional market cap weighted offerings we all know and do not necessarily love.
The use of smart beta products is something institutional investors have generally been more au fait with and, according to recent research on pension fund asset allocation from Bfinance, 43% are thinking about transferring allocations from market cap-weighted passive investments to “smart and alternative solutions” over the next 12 months.
On the retail side of the spectrum, however, investment in smart beta has been more muted and as with many newly-developed areas of the industry this has a lot to do with a lack of understanding.
This is not surprising as there is certainly no consensus on how to define smart beta. Even among the ETF community, which is where the bulk of smart beta strategies have been developed, there is a lack of agreement on what types of approach should be included under the smart beta banner.
As a growing market, is smart beta something wealth managers and advisers should swot up on, then? Perhaps not.
Yesterday Cass Business School released findings from a couple of reports it has compiled, showing smart beta offerings can put outperformance compared with market cap investment strategies down to little more than luck.
Through a study of US share data from 1968 to 2011, Cass found nearly all of 10 million indices weighted by chance delivered vastly superior returns to the market cap approach.
Sponsored by consultancy firm Aon Hewitt, the study looked at 13 alternative (or smart) indices and found they all produced better risk-adjusted returns than a passive exposure to a market-cap weighted index.
At first glance one might assume this to be a glowing recommendation for smart beta, then, but Cass has more to say on the matter.
“We programmed a computer to randomly pick and weight each of the 1,000 stocks in the sample; we effectively simulated the stock-picking abilities of a monkey. The process was repeated 10 million times over each of the 43 years of the study.
“The result of this experiment showed that many of the monkey fund managers would have generated a superior performance than was produced by some of the alternative indexing techniques. However, perhaps most shockingly we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index.
“One of the implications of our work is that we should perhaps be benchmarking our fund managers against monkeys rather than against a cap-weighted index,” Professor Clare, one of the authors of Cass’ reports concluded.
The inherent weaknesses of market cap-weighted indices have been well documented – particularly in the fixed income space – but the Cass research puts a whole new spin on the active vs. passive debate.
We have known for a long time that some fund managers are incapable of returning investors even peanuts and the reason behind exploring alternative indices is the passive space is a noble one.
But if monkeys or computers can beat humans in the smart beta space through random selection too, then the task for fund management companies to justify their fees has just gotten even bigger