What changes are needed in the smart beta sector?

Steve Artingstall: It would be good to see more acceptance of [smart beta], more understanding. Some of the factors are certainly better understood than others. The value idea of buying £1 for 50p is all very easy to accept.

Momentum is a very interesting one because people seem happy to use that in hedge funds, and yet when it is done in the cross-sectional equity space it does not seem to be seen as such an acceptable way of doing things.

I would like to see more in factor activity going on in the small cap space.

Very little is done under the rubric of smart beta. I would like to see that change in the coming years

Scott Richardson, AQR

Simon Hill: For me, it is honesty and humility I would like to see more of. Trustees know when they are being sold to and their instinctive reaction is a negative one. So if we had a bit of intellectual honesty to say, ‘Sometimes these things work and sometimes they do not’, that would be really welcome.

Scott Richardson: This is critical. Without that honesty you do not have a business model, as an asset manager.

Robert Holford: Managers are not just producing marketing materials, they are actually being relied on a bit more for insight and understanding around when a product will and will not work.

The other aspect that is quite interesting is how smart beta interacts with things like environmental, social and governance factors.

Richardson: You could think of ESG as another factor and the question is: what sign, what exposure, do you want to be long or short to that factor? It is straightforward to include in the implementation process.

If you have something that really stacks up, I think you pay it because there is no investment-led or charges-led solution

Jonathan Reynolds, Capital Cranfield Trustees

In terms of what would be nice to see, I think it is increased transparency and awareness across multiple asset classes. There is nearly £50tn outstanding in fixed income markets and very little is done under the rubric of smart beta. I would like to see that change in the coming years.

Jonathan Reynolds: I like what I hear about the humility: that is hugely important, people understanding their limitations. From a trustee perspective, investment is all about member outcomes, particularly with defined contribution.

If smart beta has a role to play, great, but it is not in any of the default portfolios I have seen at the moment. And that is where a huge amount of money is going to go in the future. You would have thought there would have been a real desire within the industry to solve that problem.

Holford: I spoke to three trustees recently, all of whom are considering it in some context. The overall cost of the portfolio was 16 basis points, and adding smart beta would have increased it to something like 21bp to 22bp. That was too much of an increase for one particular trustee.

So cost is not going away anytime soon. The fact we are talking about 6 extra basis points is interesting as we are not talking about inflated pricing at 22bp – this is now reasonably cost efficient.

Reynolds: The question for me would be simply: are those 6bp worth paying for the level of confidence it will generate within my members and the employer? If you have something that really stacks up, you pay it because creating and maintaining confidence is key; there is no investment-led or charges-led solution.

Holford: It just seems there is a complete lack of confidence in outperformance as an idea.

Richardson: I think the hurdle you should look at is: does this strategy diversify, and what is a fair fee for implementation.

Reynolds: It is all about, ‘Does my fund go down?’ If my fund does not go up by 0.1 per cent, that is not really a big issue; it is the drawdowns that will absolutely destroy confidence.

Richardson: You can package things together that offer a bit of downside protection; it could be a defensive exposure. Managed futures also has a nice property that tends to diversify left-tail events.

You can bolt things on together, each of which are powerful standalone, but the combination of them can then be tailored to someone with a downside concern.

There is a slight incongruity in-between the argument that we cannot predict, and at the same time we are saying crowding is a risk

Steve Artingstall, RPMI

Reynolds: Whoever comes up with that wins, because that is the massive challenge for that period coming up to retirement. And as we get to fewer and fewer people having any defined benefit component, downside protection becomes absolutely essential.

Richardson: Crowding is an important issue. People who are newer to this space might say, ‘Me too’ and there are all these assets flocking in to follow something – is that not a bad thing?

Holford: They are also the most likely to be harmed by it as well, because it is likely to be the retail world, more the smaller institutions that are following on from things the big guys have done very successfully.

Richardson: That is a risk, so you need to be able to try and monitor it. Can I forecast markets or factors? No. But you can look for the footprint of a herd mentality. It might be by looking at whether something has become more expensive – that reveals the footprint of asset flow.

If we then look at the securities-lending market data, we know who is shorting what and when. Do these things co-move more than they have done in the past? The big picture for the investor is: you should expect a little less, longer term, as more people become aware of it.

Also, there are levered providers for some of these strategies and there is a deleveraging risk lurking in the background. You can be prudent in how you manage that levered multi-strategy, multi-style, multi-asset class portfolio, but maybe someone else out there is doing something less prudent.

If they experience a redemption or a claim on their capital base, you can get a correlated shock to your portfolio. So you might expect a lower Sharpe ratio than you have seen in the past.

Artingstall: There is a slight incongruity between the argument that we cannot predict, and at the same time we are saying crowding is a risk and we need to look for it and be aware of it and be ready to do something about it.

Holford: I suspect while the factors and the investment strategies might change, some of the fundamental things we have talked about – asset management becoming more systematic and lower cost – are here to stay. So on that basis, smart beta is here to stay.