Laura MacPhee asks independent trustee Richard Butcher for his thoughts on investing in smart beta and his responses to exclusive research sponsored by HSBC Global Asset Management

This is an excerpt from the ’Smart beta - your guide to alternative indexation’ report, produced by Engaged Investor, in association with HSBC Asset Management. To download the full report, click here.

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How can trustees use smart beta as part of their strategies to help manage both the risk in the scheme and their fees?

Smart beta is nominally a passive fund that tracks an index. If that’s the investment profile you want, then that’s the sort of fund you would buy.

Theoretically it should have a lower-risk profile. Because it is a semi-passive fund it should be lower cost, so in a defined contribution world it should be within a charge cap environment.

How transparent do you think the fees are?

The fees are transparent in the sense that you will be quoted by any manager in charges based on the assets, and there will be a reduction in yield that’ll take into account some of the dealing costs. The wider debate – and it isn’t specifically related to smart beta – is what impact do the underlying transaction costs have on that?

Remember the Railpen experience, when they discovered that the dealing costs were significantly higher than they were led to believe. That applies to all funds, but in a smart beta fund like in a regular passive fund that should be relatively low because there shouldn’t be too much active trading going on.

The priority when the schemes we surveyed were selecting a smart beta fund was methodology. Why do you think that is?

The methodology is the key thing with smart beta, isn’t it? It’s what makes it smart. What you’re doing is saying, our starting point is that we want to duplicate the return on this index, but we’re going to mitigate the downside. You’re still constraining yourself as a fund by saying, well, we’re not going to go outside of the index. We can’t diversify into property or cash or whatever else. Then the methodology becomes crucial. How are you making that decision within that constrained environment?

The lowest priority schemes identified when discussing their decision making was brand. Why do you think that was?

If you believe in the methodology, and this is producing the performance characteristics you want from your fund, brand’s irrelevant isn’t it? Brand gives a sense of comfort, of reassurance, but it’s not the best criterion to select a product or provider with – it’s just part of the mix.

Do you think there is a risk associated with choosing a sole provider?

There is. Quite aside from that, if you’re choosing a passive manager there’s a risk – that the market goes down. If you assume that all passive managers behave in broadly the same way and have relatively similar tracking error, the risk with a single passive manager is that the fund goes down.

If you only select one smart beta manager, you’re reliant on their methodology producing the result you want to. But methodology is subjective.

If you choose two, you’re mitigating the risk of it being wrong.

Richard Butcher is an independent trustee and managing director of PTL.

This interview is part of the research report Smart Beta: Your Guide to Alternative Indexation. Watch out for more online. 

 

This is an excerpt from the ’Smart beta - your guide to alternative indexation’ report, produced by Engaged Investor, in association with HSBC Asset Management. To download the full report, click here.