By Crispin Lace
Identifying the best managers is critical for success in some markets. A hard task in itself, it also brings the unwanted complication that the best managers often have very concentrated portfolios, which can introduce unwanted style biases into portfolios.
There are a range of analytical tools available to recognise these portfolio exposures, tilts and biases allowing an investor to gain exposure to the desired risk factor. Where active management has a good chance of success, pension schemes can rely on traditional active managers to provide the added value they seek. However, for those markets where the services of a skilled investment manager are needed, one option for pension schemes to consider is the additional help of smart beta in order to control unwanted style biases.
Smart beta can be defined as transparent, rules-based investment strategies designed to provide specific exposure to broad markets, market segments or desired factors. We believe there are two specifics applications for smart beta, both of which can significantly enhance a portfolio. Firstly in can be used as an objective construction methodology that achieves a higher return per unit of risk for broad market, systematic risk. Secondly, as a construction of precision tools that allow an investor to gain exposure to the desired risk factor.
Typically, “beta” is the return an investor receives from investing in a broad market, such as the global equity risk premium. Traditionally we have measured beta as the performance of the market-cap weighted index. The market-cap weightings of companies are a market view of relative value and ought to be a good measure of each company’s economic size or importance. However, the known failings of market-cap weighted indices, not least of which is the tendency to succumb to bubbles, have led many investors, including pension schemes, to consider alternative, ‘smart beta’, approaches. There are a number of approaches that are considered as smart beta, including equally weighted, fundamentally weighted, minimum variance and maximum diversification, and they all have a role to play in capturing systematic market beta.
‘Active’ managers have begun to exploit some of the shortcomings of the market-cap approach by maintaining overweight positions to certain risk factors that were found to improve returns. This strategic use of “beta” to produce alpha is still used by some active managers but is now recognised for what it is: the reward for being exposed to a specific risk factor related to either mispricing or hidden risk rather than the reward for a skill-based decision. The precision tools that capture the rewards from these specific risks are also referred to as smart beta.
Smart beta allows pension schemes to adopt an unconstrained approach to active management – they can select the best, high conviction managers and then use a combination of risk factor portfolios to remove any unwanted risk exposures. It can be used as an alternative means to gain exposure to markets or sector; as a more focussed precision tool to target and control specific risks or to capture the rewards for systematic market beta more efficiently through alternative construction methodologies to market- cap approaches. For example, it can be used defensively in order to remove unwanted risk exposures from a pension scheme’s portfolio or proactively, by expressing any active views they have about the relative attractiveness of the different component risk factors.
Institutional investors are increasingly turning to smart beta strategies as they look to manage their portfolio risk. Given investors are now armed with these set of tools, there is strong case for redefining of “active” management to include the dynamic management of risk factors alongside the more traditional stock selection approach. Based on either qualitative or quantitative assessments, this means forming a view on the relative valuation of each risk factor and overlaying this view on the construction of the portfolio. By doing so, investors can enhance the level of return that can be achieved.
Crispin Lace is director of the Pension Solutions Group at Russell Investments
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