Avoiding behavioural biases
Although many investors find it comforting that their actively-managed strategies have an experienced, intelligent individual or team overseeing the management of the strategy, there are a number of behavioural biases which can be hard for fund managers to steer clear of entirely. This is important because various academic studies have indicated that human behaviour can be detrimental to performance. Biases that can impact performance include: selling winners too early; reluctance to sell losing positions and crystallise losses; confirmation bias (looking for new information to support the original view); reluctance to take a contrarian view; and overconfidence.
Many active managers also use quantitative filters as part of their processes in order to produce a sub-set of stocks meeting the characteristics they are looking for before applying their discretionary views to produce their end portfolio, taking into account portfolio construction considerations. Smart beta strategies provide a way of gaining exposure to a sub-set of stocks with certain characteristics without the risk that behavioural biases can creep in and have a detrimental effect on returns.
The problem with traditional passive index funds and ETFs
Investors who, for whatever reason, shy away from actively-managed funds may be drawn to passive funds or exchange traded funds (ETFs). However, one can argue that these, too, are flawed, despite apparently being so difficult for active managers to beat. For example, the heaviest weightings will be given to those stocks that have already risen the most, there is no consideration for stock, sector, or country concentration, the fundamentals of companies are disregarded, and even broad indices tend to be dominated by the top 20 or so companies.
For example, in the run-up to the dotcom bubble, traditional market capitalisation-weighted indices had very heavy weightings to the tech sector, resulting in investors being hit very hard when the bubble burst.
There are also costs associated with managing passive products, so whilst these products are generally competitively priced and well-managed, the investor will be getting the market return less costs each year, effectively locking in guaranteed (albeit marginal) underperformance over time.
How much do they cost?
The costs of smart beta funds tend to be pitched between those of traditional passive products (S&P 500 ETFs are available with total expense ratios (TERs) below 0.10%) and the sometimes lofty management fees commanded by some actively-managed funds.
The range of pricing across smart beta products is quite wide, but costs tend to be closer to those of traditional passive products than those of actively-managed funds. Most smart beta ETFs sit in the 0.25%-0.50% TER range but some are more expensive.
Conclusion
Funds that apply smart beta strategies seek to provide an investor with a way of accessing factor or style tilts in a disciplined, transparent, and more cost-efficient way. Asset management houses that offer such funds argue that they are giving investors a way to access the main drivers of outperformance obtainable from active managers without having to pay the higher management fees associated with traditional actively-managed funds.
Coinciding with a time when many traditional stock-picking fund managers have struggled to add alpha over the medium term net of fees (the US being a prime example), investors have become both much more cost-conscious and more aware of the impact of ‘factor’ exposures on portfolio performance. This combination of circumstances has served to support interest in the smart beta sector.
It is important to be wary of back-tested performance and of extrapolating live historic performance into the future. Ultimately, any index stepping away from market cap exposure is effectively taking active risk, meaning performance can vary – perhaps widely – from that of the market; styles, factors, and combinations of these can remain out of favour for extended periods of time.
However, there are some strategies that are well thought-through, underpinned by robust empirical research, focused on themes which it can be argued will continue to be rewarded, free of behavioural biases and competitively priced.
Regardless of the motivation behind the interest in smart beta strategies, it is important that prospective investors consider thoroughly the robustness of the systematic process, understanding that even apparently small differences in assumptions can have a big impact on end portfolio performance. As the old adage goes, if it seems too good to be true, it probably is.
