Gareth Stobie: Disruptive Smart Beta – ‘slowly’ eating active managers lunch

Smart Beta, as defined by Investopedia, is a set of investment strategies that emphasis the use of alternative index construction rules to traditional market capitalisation based indices. So in other words a traditional ETF on growth formula…’s Alec Hogg chats further on the topic with Gareth Stobie from CoreShares, looking at how Smart Bet is ‘slowly’ disrupting the investment management industry. And while it’s coming off a low base, it’s starting to eat the lunch of active managers, whose tools for analysis are being automated. An interesting discussion which is sure to ignite the active vs ‘passive’ debate. – Stuart Lowman

This special podcast is brought to you by CoreShares, whose Gareth Stobie joins, us now from Johannesburg. Gareth we spoke about a year ago about Smart Beta. It was a fascinating interview and lots of people were interested in it but since then your thinking on the subject has evolved somewhat.

Yes, Alec that’s right. Firstly, Smart Beta as a global topic in the world of asset management continues to evolve and grow. For starters the term wasn’t necessarily popular and broadly accepted by everyone but it sort of just stuck and is now, pretty much accepted by academics and certainly by the industry at large. It is an exciting part of the development within financial services and within asset management specifically.

It’s grabbed a lot of attention and a lot of money. Some of the managers saying that they’ve seen the flows have doubled what it was a year ago, into the US Smart Beta funds. You sent me a fascinating article in the latest Financial Analyst Journal by Kealan Lennon, which looked at the way that Smart Beta is disrupting the industry. I think there’s a lot of misconception about disruption. What do you perceive it to be?

It’s become quite a popular term, hasn’t it? The term ‘disruption’ – everything is disruptive but look, I think what that article was trying to demonstrate is to show that when an active manager agrees to take on a mandate and manage money and try and outperform the market they’ve got certain tools at their disposal. They can apply their toolset and Smart Beta has argued in that paper has taken away quite significantly from the tools available from active managers. If the active manager was charging for the use of all those tools, and a whole bunch of tools had been taken away and the charge for those tools has been dropped then, from that perspective it’s fairly disruptive. Those tools, if I can just run you through them. Really, when an active manager tries to outperform the markets the three tools that I look at – the first is to take a top down, macroeconomic view of things and try and add value through their predictions in that regard, so where are interest rates going? What is the oil price doing? The green economy, the geo-political issues and so forth, so that would be the one tool. The second tool would be the systematic quantitative processes that the active manager would apply across the market, so sieving through all the securities and through all the opportunities and looking at them from a point of view, which ones have got the lowest PE ratios or the highest dividend yield – the best return on equity, and then cross referencing those and looking at prior periods, and so forth. All of that systematic quantitative review, and then thirdly doing the real ground work investigation into the companies that they may invest in – kicking the tyres, so to speak. That’s where the asset manager will go and meet with the company that they may invest in. Assess the management team, look at the technologies, assess that company’s position, within the industry, and so forth.

Read also: Gareth Stobie: ETFs 101 – How to beat 75% of active asset managers

It sounds to me like the only one that really will survive all of this is the ‘kicking the tyres’ approach because clearly in the other issues, they are using tools that maybe machines can do better.

Yes, certainly on the second one that I’ve just described that systematic, quantitative process to screen and choose stocks, based on a whole lot of predefined rules. That, to my mind, has been automated now and has been commoditised by Smart Beta. The macro view – some will get it right and some will get it wrong. Macro views are notoriously difficult to call. You’re based in London now Alec, you need only look at the Brexit vote to show how things can move in a direction that you never expected them to, so you can have that macro view but it’s just so very difficult to get right.

Even Warren Buffett can’t get it right and he says don’t call the big picture, so if he can’t do it, I’m not going to trust anybody else to do it.

Well, there you go and then on the bottom up, kicking the tyres process. Obviously, if you do that thoroughly and well then you may sniff out opportunities but the difficulty there is to cover the full opportunity set because obviously, if you’re assessing a whole market of shares and securities – how do you do that in depth knowledge across the whole market? That requires great resources to actually fulfil that function and then that becomes a costly exercise and then ultimately that cost has to be passed onto the investor. It’s that middle ground where I think Smart Beta has disrupted the model as it currently stands, whereas before an active manager would have employed an army of young analysts to go and crunch numbers for them, so that they could make these decisions. Those numbers are now crunched by the big index houses, who have sunk infrastructure they’re employing people from a global talent pool and running quite big and established operations with wonderful research and so forth. They’re putting these Smart Beta strategies together and I think that’s really where the active management industry is being challenged. What does their skill look like beyond what is being commoditised by these new Smart Beta indices?

Read also: Smart Betas and derivatives well and good, but ETFs guys, why not start at the beginning?

Gareth, it’s interesting to go back to that article in ‘The Economist’, which suggested that active managers are getting squeezed by index funds, which we know all about, the ETF industry is going ahead very strongly, and now by Smart Beta on the other end, so it’s almost like what is their role going to be in the future, the point that you’ve made about kicking the tyres is one option but it is an expensive option. Do you buy what ‘The Economist’ is saying that eventually Smart Beta will just continue to eat away at active manager’s portfolios?

I think it will. Look, I think Smart Beta is coming off a very, small base. It represents a very, small part of the industry and I think that’s an important point of departure, so even though it’s growing and thriving, still relative to the market encumbrance it’s got a long way to go. The active management industry who dominates the market share at the moment, they’ve got a lot to lose in terms of that shrinkage in margin, so they’re going to defend their turf as best they can through aggressive marketing and so forth. I suppose the distribution, the sales people and the like, but long term – I think it will slowly erode at their value proposition. Like most industries they will evolve and start to offer value in different ways, so the kick the tyre is just one part but also looking perhaps at being experts in Smart Beta themselves and looking at how one combines Smart Beta together with other strategies, within a portfolio. I think other types of investment strategies, such as private equity and some of the niche asset classes will become an important place for active managers because there, the margin is inherently higher. For now, Smart Beta is a threat but it’s really quite tiny still, in the context of the broad industry.

An interesting point that you made there – that they’ll become experts in Smart Beta offerings, a little bit like unit trust fund or fund managers perhaps.

Exactly like that because one of the things that has happened, certainly within the Smart Beta space, is that when Smart Beta first came out I think the product providers were a little guilty of promoting them on the back of performance to say look at how wonderful the Smart Beta product has done relative to the general market? It’s an index fund, yet it’s outperformed the index. Now, we know that any strategy that outperforms the index one day can also underperform the index another day, so different Smart Beta strategies perform differently in different market cycles that we go through. There will and is already developing an industry for combining Smart Beta factors, either with other Smart Beta factors or combining Smart Beta together with other active strategies. For instance, you might want to pair up Smart Beta strategies that have got a risk management tilt to them, so quality stocks are defensive or lower volatility stocks are defensive on the one hand. Combining those with say Smart Beta strategies that focus on return and chasing return, so strategies there may include value and momentum. How you then combine low volatility, quality value, and momentum is in itself an art and something that I think the investment industry will start applying a lot more time and resources to.

Read also: Helena Conradie: Smart beta funds – index-trackers on steroids

What about the individual or private investor? How do they start getting a feel for Smart Beta opportunities, where they might employ them instead of buying individual shares?

That’s an important point because one of the duties of the growth of passive or index investing in the first place is that it’s been very pro-consumer, so the consumer has understood that if they buy this index fund, let’s say the FTSE100 or the S&P 500 or one of our JSE benchmark indices. They know that they’re buying the general market and they get that and they get that they’re buying it at a low cost. I think the indexing world has done a great job in that regard, in terms of bringing the everyday investor into the fold. What they’ve called the de-marketisation of the fund management industry as being the arrival of index funds. Now we’ve thrown the retail investor, a slightly different animal, is the Smart Beta funds, which on the one hand have the opportunity to outperform, as I was saying earlier that can underperform. Our approach to that is to ensure that certainly the Smart Beta products that we run are intuitive and hopefully do what they say on the drive, so if it’s a dividend Smart Beta strategy, well then the retail investor who is buying the dividend Smart Beta strategy expects to get a dividend return higher than the general market and the Smart Beta strategy should deliver on that objective, so it becomes quite outcomes orientated. Likewise, with low volatility – the retail investor, when they see a low volatility Smart Beta ETF they should be able to intuitively understand how they use that low volatility ETF. They maybe an investor approaching retirement and want to de-risk themselves to a degree or they might want to de-risk themselves because they’re nervous about the markets or whatever. We try to ensure that the Smart Beta products that we put out for the retail investor are intuitive and do what they say on the box.

Sorry Gareth, what’s been the most popular of them so far?

Locally, in South Africa, and of the Smart Beta products – probably dividend strategies have been quite popular. Globally that’s also been the case that the various dividend strategies have been popular. In particular, because of the low yield environment that we’ve had, certainly overseas and not so much in South Africa but that quest for yield that has been with us since the global financial crisis. South Africans, generally speaking, are still getting their heads around Smart Beta. There’s been no stand-out success story, I don’t think, amongst the various Smart Beta products. They’re slowly but surely gaining attraction but I think certainly the ones that the retail investors understand the most are probably the dividend ones.

What about institutions? You can understand it’s taking a while for the private investor or the retail investor to catch onto this but institutions, are they ahead of this curve?

They are in some instances. It’s quite strange for us, as a firm, offering these products because on the one hand the development is almost ahead of itself. There’s not a lot of money necessarily being managed within the Smart Beta strategies, yet the thinking is evolving all the time. When we meet with institutions we find that some are well ahead of the curve and they’ve got very sophisticated thinking around how they’d like to approach Smart Beta, whereas others are still investigating it for the first time. FTSE: Russell, one of the big global index houses conducts an annual survey amongst asset owners, as related to Smart Beta to see what the perceptions are out there. They’ve been running that survey for a couple of years now and certainly each year they run the survey. I think last year the number of asset owners assessing Smart Beta doubled over the course of 2015, and I think that Towers Watson, being one of the big asset consultants globally doubled their allocation to Smart Beta across their client base. It is definitely gathering attraction again, off a low base and institutions are certainly considering it. They tend to use Smart Beta to offset other equity allocations they may have given in their portfolios. Like the example I gave earlier around the quality and low volatility, offsetting momentum and value. Well maybe within the institutions allocations they’ve only got equity managers, I’m now talking active managers, who’ve given them value and momentum type returns. They may use Smart Beta quality and low volatility to offset those allocations that they’ve given to momentum and value. From a correlation perspective, try and bring in efficiencies by using Smart Beta rather than bringing in another active manager and there, the beauty for them is, well firstly they access that through a low cost, but also they know exactly what they’re accessing. The strategy that they buy into with Smart Beta is not going to change. It will do what it’s supposed to do, which is follow the set of rules that are set out within the strategy.

Let’s have a look into your crystal ball if you will, and apply that with the disruption that is happening through Smart Beta to your asset management company of the future. Are you going to either have to be very big or boutique?

We’re going to have to be one or the other I suppose, is the answer to that. I think if you’re very big then you have got muscle in whatever strategic direction you want to move or boutique, in terms of offering specialist asset classes or specialist skills, which aren’t necessarily common in the market but that sort of wishy-washy middle ground – I think those guys will struggle because to demonstrate their value add is going to be increasingly difficult.

It’s a very interesting point, isn’t it that by diversifying in that wishy-washy middle ground, as you say, they generally do okay if they follow the market whereas, you have many other houses that are dedicated to one area or one type of investing when actually the investor just wants a best possible return. So things evolving, things disrupting – you’re going to have to get smarter to stay in this industry in the long term.

Yes, I think so. I even saw an article the other day, which was an article set in the States, to say is passive investment management actually eroding the economy because bearing in mind financial services is a major sector in most economies and asset management has a fair chunk of most financial services sectors. If suddenly there’s this huge wave of low cost products moving into that part of the sector there’s a lot of revenue that’s been kind of undercut, if you’re following my argument. On the flip side of that is that the saver or the investor is getting additional returns, so the money is being returned elsewhere within the economy but it does force the industry to kind of rethink how it’s approaching things.

I would love to hear Warren Buffett’s view on that article. He’s gone on at length about the helpers and the super helpers who actually add no value to the trend.

Look, I think on Warren Buffett, I obviously can’t speak for him, but he certainly seems to be an ally of John Bogle whose, as you know, is the founder of the whole indexing world. John Bogle funny enough doesn’t necessarily like Smart Beta because he thinks it’s moving too much towards active again where you’re trying to be clever and outperform the markets instead of just investing in the markets. I suspect, without knowing for sure that Buffett may side with Bogle on that one. My kind of stance on that, as to whether Smart Beta is muddying the simplicity of passive is to say that, in my view it’s not but what it is doing is simplifying the active markets, so rather than muddying passive and simplifying active is my take.

Gareth, just to close off with when you guys start having a look at new, active Beta or Smart Beta portfolios, where do you take your lead from?

Well, firstly there are a couple of major building blocks within the Smart Beta world that is a fairly good starting point. So Smart Beta generally is spoken within four or five building blocks these days, and I’ve mentioned most of them. So low volatility, momentum, quality, value, and size – those tend to be the four or five big themes that everyone looks at and then how you approach those five themes and combine those five themes. There are other types of Smart Beta, like various theme type Smart Beta, where you say okay well I want to have stocks that are environmentally conscious for instance, and then you have an ESG type product. The bottom line with Smart Beta is that the strategy needs to be intuitive. It needs to be backed up by a good theory, a good academic theory, investment theory – it can’t just be a wishy-washy approach to constructing an index that’s different to a market cap weighted index. We look at a whole mixture of matters when we’re looking at Smart Beta specifically. Ultimately we want to give something to the client that is intuitive. That’s easy to use. That’s efficient and that’s low cost and so forth.

Gareth Stobie is with the CoreShares Group and this special podcast was brought to you by CoreShares.