Edition: June / Aug 2017
Is ‘smart beta’ the new active investing?
Globally the debate has long moved on from active versus passive to how these can be combined to assist investors optimally achieve their overall investment objectives. Jason Swartz, head of Portfolio Solutions at Satrix, believes that both active and passive funds can blend well together in a diversified portfolio. Much of the perceived disparity between the two is due to the few remaining myths that still surround active versus passive.
The challenge today is how to blend active and passive building blocks into more diversified, risk-smart portfolios. Understanding the risk factors in your portfolio will lead to better insights and more informed portfolio construction decisions.
In general, active investment managers’ processes would systematically produce portfolios with particular risk characteristics. This is due to their respective philosophies and how they filter, analyse and construct their portfolios. The passive industry is able to extract these risk characteristics (‘value’, ‘momentum’, ‘quality’ etc) for retirement funds and other institutional investors, with the retirement fund member being the ultimate beneficiary.‘Smart beta’ in full bloom
Smart beta (also called factor investing) attempts to capture those common risk characteristics (factors) such as value, quality or momentum that seek to provide investors with a compensating return (premium) over the market for exposure to that risk. It is important that these factors are implemented against an index and that no human liberties are afforded when such attributes are harvested in the capital market.
Adding a passive multi-asset class solution to your
active vehicle will not compromise performance
Further, understand the risk premia that characterise each asset class. For example, practitioners are changing the conversation from talking about bonds to the components that make up the premia e.g. duration and credit standing.
Smarter, diversified portfolio construction decisions
Within our local industry, most active managers tend to exhibit the value bias in varying degrees. Combining these managers then leads to a portfolio that has a compounded value bias. When the value style struggles (as was the case prior to Jan 2016), the portfolio is impacted directly with no mitigating influence.
There is a way to offset this risk, leading to improved diversification. For instance, momentum and value index products have shown to be inverse in character; when momentum is performing, value tends to struggle, and vice versa. Juxtaposed with the value style, a momentum style exposes you to price and earnings momentum factors – attributes you will rarely find in a domestic, actively managed fund.
Smart beta funds therefore make it possible to deviate meaningfully and systematically from the JSE All Share or Top 40 Index, diversifying across styles. One can choose the styles (risk characters) that you want and offset the ones to which you want less exposure.
No performance compromise
Behavioural finance experts say that humans are prone to emotions such as fear and greed, which leads to inefficiencies in the market. Smart beta can effectively take advantage of those inefficiencies.
It is a big misconception that, because markets are inefficient, we need an active manager alone to capitalise on the opportunities presented. This is where the evolution of smart beta plays its critical role.
No longer does an index tracker simply track a market-capitalisation weighted index (providing exposure to pure market beta), but any market or risk factor can also be tracked to realise a multitude of objectives. In that sense, choosing a particular passive strategy to achieve inflation-beating returns can very much be an active decision.
Our capital market is a closed system. Market cycles can work for and against us, and within this system there will always be winners and losers against the broad market. Active and passive can work together to help clients reach their overall investment objective, by mitigating the harmful cycles that work against them and ‘capitalising’ on those cycles that work for them, while also beating the broad market.
How skill is measured amongst active managers is important. True manager skill is rare. In the vast spectrum of products and investment managers, be careful how you define and quantify skill. Rather be curious about passive products which can assist you reach your investment objectives. Maintaining exposure to the broad market or a factor (value, momentum or quality) is one example of managing risk when one is not convinced of the extent of skill out there while trying to adhere to your overall investment strategy.
Diverse returns for portfolio construction
Understanding the source and nature of all the risks to which a fund is exposed provides clearer insight into the extent and nature of the risk premium (compensating return) on offer. The marriage between this and sound risk-management practice is pivotal to reaching one’s investment objectives.
To be truly diversified, one needs to combine an optimal blend of both active and passive. This will also enable better portfolio construction. With smart beta, factors (risk characteristics) perform more predictably and reliably over time. Smart beta (or factor investing) offers a way to focus on risks that are rewarded systematically. It is a strategy that attempts to provide investors with systematic outperformance and is designed to be more cost-effective than pure active management.
Both active and passive players have an important role in our capital market’s liquidity and price discovery. Both active and passive disciplines can be combined in investment portfolios to help trustees reach their funds’ investment objectives.