Fund Managers Too Are Investing in Smart Beta Funds

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Asset managers are increasingly wading into the world of alternative indices as their core mutual fund offerings risk losing out to external smart beta products. Smart beta strategies target underlying factors behind superior returns (factors have become so popular that they have even been included in theory-based pricing models).

Following an explosion in the number of smart beta funds and providers, there has been some consolidation across the industry. In the first half of 2016 alone, a number of large money managers bought into smart beta providers, giving them direct access to this fast-growing, semi-passive slice of the market.

In April 2016, JP Morgan Asset Management made a relatively sizeable investment in Global X, a provider of factor-based exchange traded funds (ETFs). Asset manager Legg Mason, which like JP Morgan has been building its own set of alternative ETFs, in January 2016 bought a near 20% stake in ETF provider Precidian Investments.

In May 2016, Hartford Funds acquired smart beta company Lattice Strategies.

Meanwhile, a number of asset management firms are building their own smart beta investment products rather than acquiring or investing in others.

Smart beta funds are providing a major fillip to the overall ETF industry. BlackRock, which is among the largest index providers in the world, expects the global value of smart beta ETF assets will grow from US$282bn currently to $1 trillion in 2020 and $2.4 trillion by 2025. This will be partly buoyed by investors’ demand for low-volatility indices, BlackRock predicts.

As of May 2016, BlackRock’s iShares unit managed around $67 billion in smart beta ETFs.

The biggest ETF providers are BlackRock, Vanguard, State Street Global Advisors and Invesco PowerShares. Large financial services firms including Deutsche Bank, Barclays Capital, UBS, JP Morgan, Goldman Sachs and Credit Suisse also have significant assets under management in their ETF offerings.

Smart beta: an opportunity and threat for asset managers

The growth of smart beta strategies, or custom indices, could eat into the profits of traditional mutual funds. To many investors, smart beta products have become additions to, or substitutes for, mutual funds – partly because they are cheaper.

Smart beta strategies offer an active slant on passive investing. By constructing indices that target certain risk factors – rather than traditional index construction which weights stocks by their size – smart beta indices target superior risk-adjusted returns over market benchmarks.

Factors include size (where an index targets smaller stocks over larger ones), value (undervalued versus expensive), trend (stocks with momentum) and the low-volatility strategy, among many others.

Basic modern portfolio theory suggests that greater returns stem from accepting greater investment risk, which is why modern portfolio theory cannot explain why some factors offer superior risk-adjusted returns. But some extensions of modern portfolio theory and pricing models take these factors into account when evaluating investments.

The shifting world of asset management

A number of studies say very few mutual fund managers are able to consistently beat the returns offered by the market, particularly after taking their relatively high fees into account.

Reflecting fund managers’ moves to bring smart beta products in house, many are also replicating the returns offered by hedge funds through absolute-return risk premia strategies. The result of having relatively new quantitative-based products in the market is that investors have more investment options than ever before.

Risk premia strategies are also factor-based and offer cheaper and more transparent alternatives to hedge funds. A number of institutional asset managers, particularly in Nordic countries, are taking advantage of in-house risk premia strategies.

Investors are demanding cheaper and more transparent alternatives to traditional alpha strategies, meaning fund managers will need to adapt and grow their offerings in order to stay abreast of the overall investment market.

Many portfolio managers now use smart beta and risk premia products to complement their mutual fund and hedge fund exposure.

By targeting abnormal rates of return (or those which beat the market), mutual funds, smart beta, hedge funds and risk premia can be seen as alpha strategies. They are not limited to equity markets and sometimes target fixed-income investments – a trend which is becoming prevalent within smart beta investing.

Many ETF providers, including BlackRock, offer credit-based investment strategies in addition to commodity- and equity-based products.

Alpha, a financial return measure, refers to excess return and is used to measure the value added by a fund manager or smart beta strategy.