Remaking the Markets
In nature, every action has a reaction, and the massive move from active to passive allocation has both investors and analysts wondering how it’s going to change the market—and how investors will adapt to a world in which more of the money is seemingly going along for the ride. Assets flowing into passive equity mutual funds and ETFs have more than quadrupled in the current bull market, from $65.4 billion in 2010 to $265.6 billion in 2016 (see Fig. 1). In the latest annual FTSE Russell survey of institutional investors in North America, Europe, and Asia-Pacific, three-quarters reported they are either using or considering smart beta strategies.
Source: Simfund
A recent paper by Nikolaos Panigirtzoglou, managing director-global market strategy at J.P. Morgan & Co., argues that the shift “increases systemic risk by making markets more susceptible to the flows of a few large passive products.” Market efficiency will deteriorate as good active managers are crowded out, and when crashes occur, “the correction becomes deeper and volatility rises.”
While most observers agree that the shift to indexing is significant—perhaps the most significant change in investing practice in decades—other trends are changing the investment landscape as well, and there’s no consensus about the cumulative effect on the market, or on investors. Smart beta funds, too, have been growing impressively (although not quite as spectacularly)—and some of the same forces that have boosted passive inform their rise. From small beginnings just a decade and a half ago, smart beta has grown to make up a sizable portion of institutional and even retail equity portfolios. As of March, assets in ETFs following smart beta strategies totaled $203.8 billion, or 11.6% of the total domestic equity ETF universe, up from 7.7% in 2007 (see Fig. 2).
Smart beta, which is loosely defined as index funds that weight their constituents in ways other than by market cap, such as volatility, growth, or momentum, can offer a modest premium of some 50 to 100 basis points over cap-weighted index-fund returns, both year-to-year and cumulatively, with long-term growth over the benchmark (see Figs. 3 and 4), yet fees are low. Indeed, a price war of sorts has reduced fees for many US smart beta ETFs to less than 10 basis points in the past year and some to 1 or 2. They also tend to exhibit a higher Sharpe ratio and thus a better risk profile than do standard index funds.
“Smart beta breaks the link between the price of a stock and its weight in the portfolio,” says Rob Arnott, the smart beta investing pioneer who heads $179 billion Research Affiliates LLC. “It works well because if the market soars, it says, ‘Thanks for the gains, let’s trim it.’” As a result, “smart beta portfolios have a certain amount of mechanistic price discovery embedded in their models.”
By contrast, “a lot of what people call passive investing isn’t really passive,” says Harindra de Silva, president of Analytic Investors, who oversees development of the firm’s investment models. Popular indexes like the Standard & Poor’s 500 and the Russell 1000 are managed products that aim to replicate the market but cannot do so precisely.
Arnott is less worried than some about the effect of more passive investing on price discovery and market volatility. “As for market crashes, there are plenty of other things to worry about,” he says, including “too-high valuations, reckless experiments in monetary policy, deficit spending, and low interest rates. Market dislocations are a risk regardless of indexing.”
In fact, volatility engendered by more passive investing could create new opportunities—for active managers. Panigirtzoglou acknowledges that with fewer of these engaged in price discovery, market efficiency will decline, which “would present opportunities for active managers to extract arbitrage profits.” Or, as Lori Heinel, deputy global CIO at State Street Global Advisors, puts it, “those that remain will have a better pond to swim in.”
At the same time, notes Robert Collins, managing director, investment solutions-America at private equity manager Partners Group, the public markets represent a much smaller piece of American business than it once did. He cites a March Credit Suisse report that found the number of US-listed companies has fallen by roughly half since 1996 while assets under management in private equity funds have grown by a factor of 10. “Listed companies today tend to carry more leverage than they did in the past and are not growing as fast as some other companies that are either staying private entirely or delaying their time to IPO to a much greater extent than in the past,” Collins says.
Source: Research Affiliates
“Smart beta could be seen as a way to tackle some of those issues,” he says, since it enables investors to focus on factors such as value and growth. Big data is helping smart beta managers get better at doing so, says Heinel. SSGA uses artificial intelligence systems that can “learn” to scrub enormous data sets for anomalies that could generate return opportunities.
All of which makes smart beta attractive to pension sponsors and retirement savers, many of whom are struggling to meet a liability or savings goal over the next few years or decades. “If you only invest in indexes, you’ll struggle to hit your return targets,” says Heinel, whose firm manages some $200 billion in smart beta strategies. “On a go-forward basis, you’ll need to eke out better returns, and smart beta offers an incremental return at not much extra cost.”
The California Public Employees Retirement System (CalPERS) was an early investor in smart beta strategies; the $322.5 billion fund also has a heavy commitment to index investments. Its roughly $150 billion-to-$160 billion global equity portfolio is now split roughly 60% passive, 20% actively managed, and 20% smart or alternative beta, which it runs in house with the help of its in-house quantitative research team, notes Dan Bienvenue, managing investment director, global equity.
Bienvenue agrees that the migration to passive investing creates opportunities for active investors, and CalPERS has moved in the opposite direction recently, boosting its active allocation from a 15%-to-17% range a year ago. “Our team is comfortable being contrarian, and we want to make sure we’re not chasing the market,” he says. CalPERS views its global equity portfolio as straddling a continuum from high-risk active allocations to pure index strategies, with alternative beta occupying a place in between. “What you’re trying to do with passive is to harvest growth in the economy and in value-producing companies,” Bienvenue says. “Alternative beta gives us a way to balance both of those goals.”
Since smart beta is far cheaper than active management, it may also serve as a cost-efficient complement to less liquid, more active investments like private equity that tend to have higher management fees than traditional equity investments. Private equity funds accumulated more than $1 trillion from investors from 2014 through 2016 alone, according to data provider Preqin. “There’s an opportunity for investors to take a barbell approach whereby they invest in public equity using passive or with smart beta, and then use those fee savings to make a meaningful allocation to private equity—which, on a fee basis, has outperformed traditional equities for decades,” says Collins.
Smart beta is not a panacea for investors in a market that’s rapidly being remade by the shift to passive indexing. Factors that often appear as part of the model in smart beta funds can become overpriced, underperform, and then crash, just like other strategies. Something similar occurred last year when investors piled into low-volatility funds and then retreated, for example.
“If active management was doing well, I don’t think so many people would be looking at smart beta, or passive,” says de Silva. But he expects the low fees and incremental return of smart beta to continue drawing many investors in. “As long as we have a retirement crisis and a savings crisis, we’ll have people asking where they can get those extra 50 to 100 basis points—with a good Sharpe ratio,” he says.