An increasing number of pension schemes are including smart beta funds in their portfolios. We look at what they offer

“Smart beta funds are clearly designed by humans with vast experience, but if something is too reliant on individuals then it can’t really be a beta. It needs to be a strategy that can run reasonably automatically,” says Suhail Shaikh, chief investment officer at Fulcrum Asset Management.

At the moment, we are talking primarily about funds that invest in equities according to different rules or patterns. For example, an asset manager may take a view that certain securities have a fundamental value that is greater than others’, so they may choose to invest only in those shares that they believe to have an intrinsic value according to a pre-agreed set of criteria. 

One benefit of a rules-based approach is that it has lower costs than active management – but whether or not this makes your portfolio more cost effective depends on the fund, and on your starting position. 

A scheme that decided to reallocate funds from a passive to a smart beta strategy would expect higher returns than one that was moving the money from an active fund. The former scheme would need to justify introducing a more complicated and more expensive approach. 

“We’ve seen it in terms of allocating away from their standard cap-weighting indexing allocations, or moving away from some active managers that have disappointed in the past – especially when pension funds are getting a bit more tight in terms of fees and budget that they can spend on their investment management programme,” says Ana Harris, the EMEA portfolio strategist for the smart beta and passive equities team at State Street Global Advisors.   

The traditional emphasis on offering more complex strategies at a lower cost is clear. “It’s about replicating, or recreating sources of return that hedge funds have traditionally offered,” says Shaikh. 

So it seems unsurprising that smart beta has come to the fore as hedge funds have fallen from favour because schemes feel they lack transparency or cost too much.  

The rise of smart beta

Smart beta was initially used in the defined benefit context as schemes tried to combat the low-yield environment while keeping costs as low as reasonably possible. 

The aim was either to improve returns over the long term, or to focus on reducing risk. The birth of smart beta has opened up an alternative strategy to a wider group of institutional investors, since it is not out of reach for smaller funds. 

Harris says: “There are certain strategies that look at more defensive factors such as low volatility and high quality, those that deliver better downside protection.” 

Defined contribution funds have started using smart beta more recently. Julien Barral, a senior associate at bfinance, says: “For DC it’s been more on the low volatility side, so reducing absolute risk and reducing loss in bear markets, so it’s more targeted allocation.” 

DC schemes that are being used for auto-enrolment now have to fall within a 0.75% charge cap. Smart beta funds are set up to be a more cost-effective alternative to active management, which could make them a good option, but many are still charging more than the 0.75% limit. 

Tackling the fee conundrum

Schemes should remember that the charge cap is taken as an average of the fees, so it could still be possible to include a fund that charges 0.8%, for example, provided that is balanced out within the broader portfolio. 

It should be possible for auto-enrolment schemes to use smart beta if it is appropriate for them, but trustees must weigh up all their objectives and cost considerations. 

Barral says: “On the DB side clients have looked at smart beta as a substitution of active strategies, so basically accessing alpha at a lower cost, and basically a bridge between active and passive management.”

Trustees should keep their overall objectives in mind when monitoring their smart beta funds to make sure they are performing as expected, and fulfilling the role within the portfolio. 

Again, the appropriate benchmarks will differ from scheme to scheme depending on their starting points and end goals. 

Harris says: “If you are allocating away from passive, or from standard benchmarks, then you’re more concerned about tracking error, whereas if you’ve allocated away from active managers maybe you’re less worried about tracking error than you would be, depending on where those funds have come from.”  

Schemes moving from a passive cap-weighted allocation could legitimately compare their smart beta returns against a similar cap-weighted index, as this would show where they might expect to be given the market conditions.  

There is a fundamental reason why monitoring the performance of smart beta funds is so challenging. 

“The point is to differ from a standard benchmark – in a way it’s hard to compare a standard benchmark, but I think it’s still a basis for comparison, so clients will still look at MSCI World for their smart beta global equity strategy, just to see if they do better,” says Barral. 

Smart beta versus standard indices

This apparent contradiction makes more sense than it might first appear to, since the point is not just to differ from the standard benchmark – it is supposed to be an improvement.

In the pensions context this means that it should deliver better risk-adjusted returns. 

 “The proof of the pudding is going to be in the eating, and the returns will show how good the smart beta fund was in due course,” says Richard Butcher, managing director of PTL. 

He adds: “It’s never going to stray far from the pure beta fund, it’s always going to be beta plus or minus a margin. The trick will be to look at why they have underperformed, or what’s caused their tracking error. That’s going to be the judgement of the fund manager.” 

Richard Yasenchak, senior vice president and client portfolio manager at INTECH, says: “When you invest in a smart beta fund that gives you a particular exposure to a factor, you want to make sure that the exposure is explained by the factors of the smart beta strategy, and not by unintended exposures over time.”  

The situation Yasenchak gives as an extreme example is low-volatility investing, which he says tends to have big sector bets, chiefly with utilities and staples, and tends to have smaller capitalisation. 

He asks: “Is it really the size that explains the performance, or is it really that low volatility exposure that’s explaining it? We want to understand that exposure and ensure it is true to the kind of factor you want.” 

Creating a strategy

Providers can help make this process easier by trying to isolate different factors at the modelling stage of creating the smart beta fund. 

Of course, trustees will have to be clear on what type of strategy will actually help their scheme meet its objectives before beginning to consider a smart beta product.

After all, a fund could achieve performance through its low volatility exposure but if that undermines, or at least does not advance, its overarching goals then it will not be appropriate.   

As smart beta is still a relatively new kind of strategy, in theory at least there should be plenty of scope for development.

Barral says: “The beauty of smart beta is that it is customisable, so each client will probably have a slightly different solution, depending on what they already have. 

“The evolution would be more customised strategies that would fit well with what the client has and their objectives.” 

Some in the sector are not convinced, though, and think smart beta could be more of a passing fad than an evolving strategy. 

“[Smart beta funds are] flavour of the month at the moment, and as a consequence they’ll get a toehold, then a foothold, then an armful of the market,” says Butcher. 

“They are a valid tool, but I don’t see them taking over the world. They’re not the answer to all of our problems. Once they’ve established themselves they’ll have parity with all the other investment strategies that are available,” he concludes. 

The way forward

However, there are specific ways in which the market could develop. 

At the moment smart beta is firmly focused on equities, but there has been some interest in extending the principles to other asset classes, particularly fixed income. 

Harris says: “We’ve seen a lot of interest in what factors can be captured through these transparent, rules-based, smart beta strategies and indices in the fixed-income world.”   

Smart beta funds are already starting to move in this direction – as Shaikh points out, the biggest development over the past three or four years has been the creation of multi-asset versions. 

This seems the most likely development in the smart beta field, but providers will need to be careful that this approach actually works in different contexts. 

The name ‘smart beta’ may sound Lauragood, but it will have to deliver if it is going to survive.