Following a recent seminar (Eyes on Asia as Fresh Trends Emerge) for investment professionals in Hong Kong in mid-May, SRP caught up with Tim Edwards (pictured), senior director of index investment strategy at S&P DJI Dow Jones Indices (S&P DJI), on his return to London to discuss how smart beta is making inroads as a transparent and cheaper alternative for structured products, exchange-traded funds (ETFs), futures, and options; and how the fixed income segment of the market is poised to drive the development of new indices.
During the financial crisis, says Edwards, many investors discovered that they weren’t quite as diversified as they had supposed. “Previously muted risks – such as liquidity - took the driving seat and the correlations between assets rose,” he says. “In fact, it turned out that in a stress situation many of their investments – even though they were in different asset classes –were exposed to similar economic risk factors and premiums.”
This, according to Edwards, resulted in several institutional investors (particularly the larger pension funds) asking how they could diversify not just across-asset classes but also across risk factors, too, something that in turn, led to the need of measuring different risk factors more precisely, and eventually a demand for products that delivered those factors in an efficient format.
“Beyond the institutional space, there has been a growing awareness that the returns from certain styles of investing – styles such as an maximizing dividend income, value investing, or risk mitigation strategies – could be characterized by a fairly simple set of rules,” says Edwards. “The simple set of rules can then be applied to create an index, and the returns from those styles can be accessed through index-based investments at a lower cost than the pre-existing alternatives.”
According to Edwards, ‘Smart beta’ is ultimately a marketing term, but the set of strategies it is used to describe are growing thanks to more than just “clever marketing” as there is a clear value in the ability to formalize and offer these types of investment without the associated costs of active management.
Passive v active
As a result of the increased availability of strategies that can replicate the role of an active asset manager, fund managers are being put under pressure to justify their fees.
The travails of the active asset management industry did not end with the crisis, says Edwards adding that in fact, its own research shows that in 2014 the active mutual fund industry had one of its worst years ever in the US – with 87% of US domestic equity funds underperforming a market-cap benchmark.
“In Europe the situation is little better, with 83% of European-based equity funds underperforming the S&P Europe 350 in 2014,” he says. “Such performance has resulted in more than just an increasing demand for passive equivalents. One of the reasons given for this lack of performance is that [active] managers were hugging their benchmarks too closely and, nowadays, there is a lot more pressure on asset managers to be ‘more active’.”
Investors, says Edwards, are more keenly aware that the market’s returns as well as those available from the basic investment styles are available quite cheaply elsewhere. “Investors want their managers to focus more specifically on the excess returns to their unique insights,” he says. “In other words, active managers are being asked to use a higher conviction, to deviate further from their benchmarks and to more clearly show their value.”
According to Edwards, active managers are also being judged differently, with different benchmarks, as opposed to being judged by their performance compared with the market as it used to happen “fifteen years ago”.
“Nowadays, investors might examine the manager’s exposure to value, size, low volatility, and high yield factors - for example – and compare their performance to an index based in the same market but with similar factor tilts,” he says. “This makes the benchmarks harder to beat through factor tilts alone, but it also means that managers can better cope with some periods of underperformance (if you like value investing and hired a value manager, during a period of losses it might be that the manager is still outperforming a value index).”
Smart beta pitfalls
Despite the pros around smart beta strategies to address many needs from an investor’s perspective, the pitfalls are not to be underestimated, says Edwards.
“Factor investing is not infallible, and it is inevitable that every example of a ‘smart beta’ index so far invented will have some period of underperformance versus the market,” he says. “Investors should be aware of that. They should ideally also have a clear picture of what kinds of market circumstances will drive such underperformance – and whether they expect it to happen.”
In comparison to active management, it’s a different investing experience, too, as active managers can learn from their mistakes, apologise for them and give investors hope that the future will be brighter, says Edwards.
“Indices follow a pre-determined methodology and the onus is on the investor to understand what the index is doing and if they are comfortable with it,” he says. “The bulk of the fiduciary responsibility, it might be argued, lies with the person selecting the index.”
Edwards believes, however, that on a more emotional level, if an investor loses money with an active manager then he/she can blame them (even sack them) for performing poorly.
“Provided it is calculated properly, an index is just doing what it is supposed to,” he says. “That sounds trivial and obvious, but it actually becomes important when you think about issues like fiduciary responsibility, accountability and governance.”
According to Edwards, combined with the growing modern demand for low costs and transparency, the result of these trends was a demand for products that could deliver similar returns to what hedge funds might achieve, but at a lower cost and that could be replicated in a more liquid manner.
“Some of it can be and has been achieved through indices, and through index-linked products,” he says.
Fixed income
The hunt for yield over the past few years, generated by both extensive quantitative easing programmes and a low interest rate environment, has resulted in a fund allocation shift towards either riskier assets or longer dated fixed income instruments, but this segment is changing and index providers are moving to leverage their infrastructure to build indices that can add value and offer exposure to fixed income strategies in a more efficient way.
After the Libor scandal, says Edwards, regulators and investors across the world asked questions about benchmarks that have very complex methodologies and that could not be replicated (but could be manipulated).
“The concerns around FX and Libor have of course manifested in record fines for the industry, and although there have not been any scandals of similar scale in the wider fixed income arena, investors have raised concerns,” he says. “Simply put, there is a growing need for transparent benchmarks. We believe that we have the capabilities to provide that.”
In addition, says Edwards, investors are increasingly asking for indices that are independent from the provider of products and from the provider of prices. An index provider, that is truly independent, should not manage, trade, or issue investment products based upon its indices – a model that S&P Dow Jones Indices has had in place for a long time now, according to Edwards.
“That being said, S&P DJI has been calculating fixed income indices for some time and – taking ETFs as an example – we are one of the leading index providers in terms of assets linked to our indices,” he says. “Examples include the S&P Municipal Bond indices, which have become de facto the country’s municipal bond benchmarks; and we’ve also shown we can innovate - the S&P Green Bond and S&P Green Projects Bond Indices launched last year are good examples.”
However, says Edwards, S&P DJI’s ambitions in this segment are bigger. “We have started with a global aggregate, a US aggregate, and eventually we’ll cover all the major markets and segments, countries and regions etcetera,” he says. “We are also building smart beta versions, which has been something our clients are particularly keen to see.”
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