Fund providers reject warnings over smart beta’s potential to go ‘horribly wrong’
Funds that mix active and passive approaches have proved very popular
Even set against the sharp rise of index investing over the past half decade, the popularity of smart beta strategies stands out. Yet demand for the products has reached such a level that some of their biggest adherents warn they could soon become victims of their own success.
As the growth of smart beta shows no sign of abating, fund providers have continued to roll out products designed to act as a halfway house between active and passive management. Global assets in smart beta products — which work by tweaking a passive investment approach to generate above market returns — have grown by close to 600 per cent since 2008 to $707bn at the end of October 2016, according to data provider Morningstar.
But such rapid expansion has prompted even the strongest proponents of smart beta investing to voice concerns. Rob Arnott, whose company Research Affiliates created the world’s first smart beta indices, warned this year that some strategies could go “horribly wrong”.
Smart beta strategies typically exclude stocks that have demonstrated extreme volatility. However, product proliferation and funds aggressively chasing performance could ultimately leave investors nursing heavy losses, he warned.
“Are we being alarmist? We don’t believe so. If anything, we think it’s reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies,” Mr Arnott wrote in a research paper.
Mr Arnott argued that if all smart beta products simply chase performance, then perhaps they are not very smart at all. Yet concerns voiced by the so-called “godfather” of smart beta have done little to diminish strong investor appetite.
According to a survey published in November by Invesco PowerShares, a smart beta exchange traded fund (ETF) provider, more than 71 per cent of investors surveyed indicated they are willing to increase their smart beta allocation. The research revealed a high level of satisfaction among smart beta users, with 96 per cent stating the vehicles performed as expected.
Bryon Lake, head of Invesco PowerShares for Europe, the Middle East and Africa, says Mr Arnott’s comments should not be interpreted as an attack on smart beta. “In many ways [Mr Arnott] put smart beta on the map. He was saying investors need to do their due diligence, whether it’s active, passive or smart beta. They need to understand what they are buying,” Mr Lake says.
“One of the benefits of investing with smart beta ETFs is that they are 100 per cent transparent. You can see the ETF holdings and investors have the ability to understand what is in an ETF.”
One of the reasons behind the continued success of smart beta is a growing awareness of the investment approach among investors, says Mr Lake. “Portfolio builders are becoming experts in using smart beta and have a better understanding of how they can use it,” he says.
Others believe intense criticism that active funds have received for consistently failing to outperform their benchmarks is spurring investors to hunt for alternative investment vehicles with an active flavour.
Deutsche Asset Management, which has $1.5bn in smart beta ETF assets according to consultancy ETFGI, expects further smart beta growth with investors using the products as “an ideal substitute for underperforming actively managed portfolios”.
Unsurprisingly, product providers are keen to prove Mr Arnott wrong when it comes to his concerns about smart beta.
“It is not only about chasing performance,” says Martin Weithofer, head of strategic beta at Deutsche Asset Management. “Strategic beta building blocks can play an important role in improving the risk and return characteristics of a passive portfolio, especially if we are talking about relative or absolute risk reduction. It’s also a cost-efficient alternative in a low-yield environment.”
However, others believe Mr Arnott’s comments could be justified, as smart beta products are no less fallible than other mainstream strategies.
Robert Holford, head of strategic consulting at Spence Johnson, an adviser to asset managers, says: “Things could go horribly wrong with smart beta in much the same way that value strategies run by fundamental managers could go horribly wrong during a crisis.”
He adds: “Concerns are justified that people are loading up in certain areas, but smart beta providers are aware of this and have introduced value elements to make sure they are not loading up on the most expensive stocks.”
Deutsche’s Mr Weithofer rejects accusations that the chasing of performance among smart beta funds could lead to investors experiencing losses on a similar scale experienced by quant funds in August 2007.
During a one week period, several quant-driven hedge funds suffered heavy losses on the back of the subprime mortgage crisis, causing a sell-off among funds pursuing similar strategies.
Mr Weithofer says the situation is very different for ETFs that are highly diversified, track indices as closely as possible and do not take on debt.
“This is a million miles away from concentrated long/short funds with high leverage as we’ve seen in the past,” he says.
“There is little evidence to suggest that there is any more of a propensity for a bubble to form in smart beta than there is in standard beta.”