API Active portfolio management – a response to ‘smart’ Beta or Style Investing
In previous articles we highlighted that active portfolio management benefits from:
- the ability to rebalance the portfolio as opportunities arise and
- that a wider range of stock choices is beneficial and improves the likelihood of achieving positive active return – that is a return in excess of a relevant market measure or index fund.
Choosing between stocks allows an active manager to pick the ones that they believe will perform better than average, whereas an index fund will provide exposure to all of them regardless of return and risk.
Index fund management provides exposure to all the stocks and rebalances on a fixed calendar basis regardless of whether there is any point in so doing.
However new kinds of index funds are gaining acceptance and for good reason. These are known as ‘smart’ Beta index funds. Having acknowledged this, we note in an article published recently by Institutional Investor that there is growing acknowledgment of the hidden, unexpected and potentially uncontrolled risks that are present in rule-driven, factor-tilted products.
This is the third article in the API series on identifying risks in passive investment approaches and how to improve on ‘smart’ Beta strategies. We will discuss the growth of ‘smart’ Beta index funds and whether they overcome any of the advantages of active management, or indeed compensate for any potential disadvantages in active management.
Some background to ‘smart’ Beta
The rules for ‘smart’ Beta index construction are similar to those employed in building market cap indices but features other than the market cap of the company are applied to calculate the weights of the stock within the investment universe. It is that simple!
Such constructs have been around longer than many commercial proponents of ‘smart’ Beta care to admit. The Dow Jones 30 Index, for example, is a price weighted index where the constituents are weighted by their share price not by their market capitalisation.
However, there are now over US400billion in smart beta exchange traded products offered in the United States so they have gained acceptance.2
Many readers will be well aware of Value and Growth investing styles which have been around since the 1930s. Value investing was popularised by Benjamin Graham in his book “The Intelligent Investor” that inspired many followers like Warren Buffett, Bill Ruane, Walter Schloss and Michael Price to name but a few. Value investing was originally focused on buying “cheap” companies – low PE, high dividend yield, low Price/Book – are some of the targeted “factors”.
As the market became more efficient and some of the criteria that Graham outlined in his book became harder to find, other variants grew up. So investors would buy stocks where they were trading below “intrinsic” value which became a little harder to define. This might include valuing each subsidiary within a business on a “sum of the parts” basis. It also included valuing future cash flows – but all evidence shows we are all pretty hopeless in forecasting more than two years ahead – and even two years is difficult!
The Growth school focuses on identifying companies growing earnings above the market average. Some particularly favour companies where there is evidence of accelerating earnings growth and where earnings continue to be revised up by the investment community (brokers following the companies). They are less concerned with the valuation believing it is often difficult to value these companies, but believe that investors will chase these stocks higher on news flow and “glamour” – think Amazon, Facebook, Google, etc. Some growth investors may use a yardstick like PE to Earnings Growth rate to ensure they are not overpaying.
There are other more nuanced schools of thought – recovery stocks, deep value, event driven, quality, high free cash flow, etc, but most of these are subsets of growth or value investing.
Many professional investors set out their stalls as either broadly, “Value” or “Growth” investors, and market themselves as such.
‘Smart’ Beta returns over time
So how have these different style actually performed? As you might have guessed – it all depends on the measurement period! Yes, life is never simple, but you knew that! So there can be quite long periods when “Growth” investing is in favour and “Value” performs relatively badly, and vice versa.
Over the last 20 years or so Value generally, across the world has outperformed Growth. But this masks a number of lengthy periods when Growth beat Value – for example since the financial crisis in 2008.
For reference we attach a table of ‘smart’ Beta index returns which illustrates our point about the time period being measured.
So what is wrong with ‘smart‘ Beta?
We should be clear and state that we thin ‘smart’ Beta is a beneficial trend and will highlight many growth and value managers who are unable to beat a style-based benchmark on a risk adjusted basis. As such how can they command an active fee?
However, they are not necessarily the optimal solution for investors and we list the reasons below.
- It is hard to predict when each style will outperform or underperform.
We have done considerable work in this area and while there is a tendency for Growth to outperform Value when economies are relatively weak and interest rates are low and vice versa, it isn’t quite so simple. These statistical relationships between macroeconomic variables and style performance are not strong enough to be consistently relied upon. Consequently, if you can’t always time single factor style exposure, it is better to have exposure to some of them at all times. This of course, tends to make the aggregate portfolio a blend of the style tilts and so there is added complexity in ensuring you have optimal diversification and not amplification of the style factors you choose.
- Such indices are often rather crudely constructed and ignore risk and investor risk appetite.
Risk and investor risk preferences matter but are ignored in ‘smart’ Beta index construction methodology.For instance, if two securities in the same industry or country have a similar exposure to a desired factor, but one is more volatile than the other, how should you allocate weight to each them? The simplistic approach adopted by many smart beta products doesn’t consider this and allocates either on the basis of equal weight or market capitalisation. These simple weighting approaches cannot consider that the riskier security effectively has greater uncertainty associated with its style factor exposure and hence should have a higher expected return as compensation for choosing to own it as part of the portfolio.
Failing to control risk introduces unintended bets, produces inefficient portfolios and can result in portfolio performance being driven by exposures to market, industry, country and other risk index factors.
Smart Beta makes dumb portfolios
- Construction rules can also impose other limitations.By rebalancing on a calendar cycle there can be lags in the information embedded in the index construction and outdated information compared to the market, that a continuously evolving investment process can better appraise and respond to in a timely manner.
- You can have your cake and eat it. Combine a style tilt with active portfolio management.
The best of both active portfolio management and smart beta rules should combine sound stock selection and sophisticated, risk-controlled portfolio construction techniques to determine security holdings and weight.This approach more efficiently provides the style factor premia without needlessly holding securities that have a partial or tenuous association with that type of style factor return – we endeavour to do this as active managers, and call this “building smarter portfolios”
There are significant benefits to this risk-controlled approach compared to implementing a smart Beta index:
- Better portfolio construction: security selection and weight allocation focuses on maximising risk-adjusted returns from the desired style factor exposures in the most efficient manner.
- Risk control: greater control of risk preferences and factor exposures avoids performance discrepancy arising from unintended bets.
- Cost control: better turnover and portfolio cost control is achieved from holding fewer securities and managing trading activity.
- We completely embrace the use of smart beta and have been involved with the development of style factor strategies for many years.
- We believe an active approach to factor investing is the best way for investors to successfully take advantage of this market evolution.
How should I think about ‘smart’ Beta index funds?
- Style, or ‘smart’ Beta based investing provides some advantages in the pursuit of active investment performance.
- As an investor there is better control around the desired type of style factor risk premium, which market sectors to target, and greater accountability of sources of portfolio return for the manager.
- We believe ‘smart’ Beta provides a better way to measure active manager performance than a cap weighted index or peer universe.
- If the philosophy of the manager can be captured using smart beta rules then any active fee should only be paid for improving on the risk return profile of the smart beta, not the cap-weighted index.
- Building and implementing a strategy based around capturing style factor exposures shouldn’t mean outsourcing the investment process through replicating the rules of a smart beta strategy from an index vendor.
Thanks for reading this far. This is the last in this series. We love investing and its challenges and wanted to share with you some of our views on how to approach active fund management.
Our conclusions on why active management should be a key piece of any portfolio are listed below. Please get in touch if you wish for more information(!) or wish to disagree.
- Active fund management allows for rebalancing on a timely, event and opportunity basis which is not what ‘smart’ Beta or any rule-driven index construction facilitates.
- Using a lot of stocks is preferable to using only a few but if you use them all then you end up with an index fund performance – you need some skill to add value even if it’s risk reduction.
- Smart Beta is useful but it makes dumb portfolios – we believe it is only a complement to skillful active management albeit a useful one.