Learning to Love Smart Beta

Big institutional clients are pushing out expensive active managers and replacing them with low cost smart beta ETFs.

The Smart Beta (or Strategic Beta) Revolution is here, and it’s up to advisors to get on board and give in to the adverse nature of the strategy, said Jason Hsu, founder and chairman of Rayliant Global Advisors, during his presentation at the Morningstar ETF Conference in Chicago.

What’s even better now, he said, is smart beta ETFs allow advisors to access the strategy at a low cost.

He further pushed the crowd by stating big institutional clients have already moved into strategic beta funds, adding they are, in fact, pushing out expensive active managers and replacing them with low cost smart beta ETFs. “This means lower fees on the entire portfolio and probably better performance,” he said.

Hsu noted:

• Consultant Towers Watson doubled its smart beta AUM from $20 billion to $46 billion in the last two years.

• Morningstar shows $300 billion in smart beta products.

• 40% of big pensions in Europe and UK and 20% in the U.S. have adopted the style in some form.

• Half of smart beta users have allocated 10% of their equity portfolio, and 60% will continue to add to that exposure.

• About 75% of asset owners have used smart beta to replace their passive products, taking share from traditional flow, and 64% of investors are replacing some of their active products.

CalPERS, with an AUM of $300 billion, has 18% of its equity portfolio in smart beta products. Similar stories are told of UK pensions. One is cutting out its hedge fund investment and putting it into smart beta. Hsu said the thinking is, “Why pay a higher fee when you can replace with lower cost product and get the same exposure?”

With this tidal wave of acceptance, the question, Hsu said, “is no longer should I [use smart beta products], but when do I get in?”

Hsu detailed alpha decomposition, showing its split into two parts: cyclical and persistent. He noted persistent performance is “most related to true skill,” but cyclical is both dramatically positive and negative and washes itself out, but it’s what dominates returns and manager experience.

His conclusion was that so many decisions and so much advice are trend chasing in nature, regardless of advisor or investor experience. “It’s intuitive to you…. That means investor outcome is about 200 to 400 basis points behind what managers report because almost all investors time, and time aggressively.”

Another example he noted was, over a three-year period, it was normal to keep the successful managers and cut out the loser managers, but in the longer term, it was the ‘loser’ managers who did as much as 250 basis points better than ones who were successful over that shorter period.

The same thing goes for stocks. People buy what’s hot, even if it’s expensive. “You need to be more countercyclical; take profit if a particular manager or style factor has been successful and rebalance it into what has been less successful,” Hsu said. “Short-term success has nothing to do with long term skill of manager or value…it is mean reverting to cyclical boom or bust.”

He urged investment skepticism, saying, “Recognize that we are always timing, so pay attention to decisions you make  when reviewing managers, new products. Realize 50% is timing!”

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