Smart Beta: The Third Way

Preview of the 2013 Risk Management Conference.

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mouse and maze_edited-1As a speaker at this summer’s Risk Management Conference in Muskoka (August 13 to 15) Vijay Vaidyanathan, research associate with EDHEC-Risk Institute and CEO of Return Metrics Inc., will lead a seminar on integrating smart beta and active management. In advance of the conference, we asked Vijay a few questions the origins of smart beta and its application to pension portfolios. To find out more about Vihays presentation and the Risk Management Conference, click here.

Where does smart beta come from?

Until recently, the investor choice that you had was an either-or choice between active or passive management. With active management, you hire an active manager who charges you somewhere between 80 and 120 basis points to actually bring his or her skill to bear to build you a portfolio that outperforms. If you don’t believe that’s possible (because there’s all kinds of reasons to doubt whether that’s possible) what investors have been forced to do is go with passive management, which for most people means a cap-weighted benchmark.

What we’ve been seeing over the past 10 years has been a lot of support for the idea of so-called “smart beta:” purely quantitative index construction methods that are still very similar to indices in the sense that they are transparent and passive. No one is exerting some kind of subjective judgment in order to form the portfolio, and you don’t need to trust a black box quant model. On the other hand, they are not passive in the sense that it’s not a simple buy-and-hold portfolio because you do require some sort of rebalancing; it’s not simply a passive cap-weighted portfolio.

Where does smart beta fit in?

These new smart beta portfolio benchmarks are a very fascinating third way – they don’t force you to pick an extreme position that says I’m going to pay a human being who’s going to charge me 80 or 100 basis points for skill that I hope they possess or the other extreme where I’ll just take the passive side of a cap-weighted portfolio, which we know has many flaws and limitations. Smart-beta is a new class of indices that are really trying to find an alternative, which is to preserve the advantages of the passive approach, namely low fees, complete transparency and predictability of style.

You don’t have to fire your active manager. Your active manager actually does bring some value to the table, even if it’s not outperformance. When there are deviations from the cap-weighted portfolio, if you have a good, eloquent active manager, he or she can make the case about why this is the smart thing to do.

I’m not saying that you need to keep all of your active managers, but I believe that there are some active managers that you probably want to keep and my interest is to better understand how I might be able to use these smart-beta techniques to work with the existing active managers.

Does smart-beta apply as well to small-caps as it does to large-caps, given liquidity constraints?

It definitely does, although it makes some things a lot more tricky and it’s one of the things I’m thinking of looking at. Right now I’m working on an allocation for a pension fund where we’re constructing a smart-beta portfolio for them in the emerging market small cap space. So you can imagine that that’s a real difficult piece. The pension funds says, “I can stomach a certain amount of illiquidity because we have a duration in excess of 15 years in our liabilities. If we cannot take on some illiquidity who can?”. This allows us to try and utilize some of these smart beta techniques to construct a portfolio that may not have the high liquidity normally associated with a conventional index, but is still likely to be a better alternative than a conventional cap-weighted index.

What percentage should institutional investors allocate to smart beta?

That’s a tough question. For me, it would be 100%, because we’re not trying to outperform by using market-timing, exploiting mis-pricing or any of those subjective, skill-based active approaches. We’re just trying to do exactly what your portfolio allocation is supposed to do, which is to get you the market risk premium that you’re entitled to but in a controlled, thoughtful smart way. That’s all it is.

To learn more about the Risk Management Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Alison Webb to be considered, as limited space available.

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