Better Off With Better Beta

Smart beta is an ideal way for investors to access the best aspects of market diversity at modest cost and governance, according to an article in Towers Watson’s annual Global Investment Matters publication. The company suggests that diversity through smart beta can help to manage risk, while implementation of the ideas behind it allows investors to exploit competitive advantages. In addition, it asserts that many institutional investors will have to hold risky assets for longer than expected in order to generate required returns and that smart beta would be a good way to reduce dependency on equities while doing this.   

Phil Tindall, senior investment consultant at Towers Watson, said: “Investors know they need to make their assets work harder but some are probably unwilling players in the risk-taking business, especially if it is for significantly longer than they had planned. However, the alternatives are similarly unattractive: safe assets now very expensive due to excess demand and financial repression. While being in the risk business for the long haul may be the unfortunate reality of current investment life, the arguments for risk mitigation with diversity through smart beta provides some hope; perhaps more so over the longer than the shorter term.”

In the article - entitled Long-term risk: get smart (beta) - Towers Watson disputes the common thesis that equities are ‘good for the long run’ and suggests that while diversification has been a text book answer to the problem of risk concentration, it has also increased complexity for investors. It suggests that smart beta ideas embody a number of concepts that improve on traditional approaches to diversification. Indeed the article reveals that the historical return pattern for a combination of smart beta strategies compares favourably to global equities, while acknowledging the period used for the comparison was a difficult time for this economically sensitive asset class.

The article asserts that the implementation of smart beta ideas as diversifiers may not be for everyone but suggests some investors have the potential for a competitive advantage from three main premia:

Risk premium - long-term investors that can absorb left tailed risks over the shorter-term should receive a premium, since other market participants are willing to pay to avoid these risks. Understanding risk tolerance and management is therefore important. In practice, most investors have a number of ‘risk buffers’ that can be used to absorb differing levels of downside outcomes.

‘Complexity premium’ - smart beta ideas require more governance than ‘plain vanilla’ assets such as equities and bonds. This requires expertise in understanding strategies, risk and position sizing, and monitoring. However, diversity with smart beta might be good governance budget spend for investors with moderate capabilities.

Liquidity premium - investors with less need for liquidity are better able to focus on the long-term journey and take advantage of a premium demanded by those who cannot.

Phil Tindall said: “There are also a number of rational reasons why diversifying strategies such as reinsurance, commodities, emerging market assets, volatility premium and momentum strategies should offer a premium when accessed via smart beta. Smart beta is simply about trying to identify good investment ideas like these that can be structured better, whether that is improving existing beta opportunities or creating exposures or themes that are implementable in a low cost, systematic way. Certain types of investors can and are taking advantage of these opportunities and we expect this to accelerate, but investors need to maintain vigilance around price and proposition.”

Global Investment Matters covers topical investment issues and this year includes articles on:

Manage pension risks better and add value – how risk management  can positively affect your pension fund

A question of governance – three pension funds discuss their different governance models

Management of risk by multinational companies – what companies are doing about the financial risks from their Defined Benefit pension schemes

Will fund managers learn to love social media – as investment managers are constantly striving to differentiate themselves, can social media help?