Focus on low-cost building blocks

Interview with Peter Westaway – Writing in the Financial Times on 27 May 2012, Jeff Molitor, CIO Europe, Vanguard Asset Management said that “smart beta should never be thought of as a perpetual motion alpha generator”.

Molitor’s point is that if smart betas really are that smart then by now everyone would have jumped on the bandwagon and arbitraged away any market gains.

Smart beta is not, in Vanguard’s view, a magic bullet that can offer investors endless years of outperformance.

Over the short-term, though, the results can play into the hands of smart beta; something that Peter Westaway, Chief Economist, Europe, at Vanguard Asset Management is quick to accept. He notes that in recent times certain styles like fundamental weightings (which are biased towards value stocks) have indeed outperformed and that it is therefore easy to portray smart beta in a positive light:

“We’re not openly hostile towards smart beta, we just think investors shouldn’t be duped into thinking that this is in any way changing the laws of finance. Typically, what these products are doing is tilting away from the market index in a particular direction and those tilts are effectively active bets, often in favour of either small-cap or value stocks,” says Westaway.

Two issues need to be addressed, suggests Westaway. Firstly, investors must not expect that just because certain styles appear to have outperformed in the recent past that they will continue to do so in the future. Secondly, if smart beta products really are just tilts in a particular direction – value, momentum etc, - then index providers should be up front about it. Don’t make them sound smarter than they actually are.

Smart beta is certainly an evolving space that polarises opinion. As noted previously, Vanguard is not against it. What it does disagree with is the notion that such products are somehow a cure-all for the vagaries of portfolio construction. They are not.

One element that Vanguard is particularly in favour of is the low-cost building block element that smart beta offers. “Rather than choosing active managers who charge 250 basis points for their stock picking expertise investors are starting to move more towards low-cost building blocks where the active element is in-built.

“That’s certainly something that interests Vanguard where we focus closely on low costs.

“Where we are more sceptical is that there’s a magic formula that allows us to combine those low-cost building blocks in a way that generates alpha on a sustainable basis.”

Cost is another potentially grey area. It’s well known that transaction costs drag on the performance of active managers. Indeed, Vanguard’s own research suggests that in a zero-sum market, only 50 per cent of active managers can expect to win. Add in transaction costs, and some 75 per cent or more of active equity managers underperform their chosen benchmark longterm.

“Smart beta goes beyond mere passive index products but how do you then bundle together low-cost building blocks? If smart beta products can do it in a cheaper way to passive strategies fine, but I’m not totally convinced they can.

“The point is you’re probably paying more for smart betas and that’s because they are effectively an active strategy. As such they should be treated with a pinch of salt,” suggests Westaway.


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