Towers Watson, a keen promoter of smart-beta strategies for its big fiduciary clients, has come up with a term for us to categorise the old-style beta: “bulk beta”. More importantly, the consulting firm has produced a paper describing the implications of smart-beta trends for what we used to know as “alpha”.
The paper ‘Into a New Dimension: An Alternative View of Smart Beta’, looks at four major facets of the smart beta trend. The fundamental implication is that this is no fad – it’s a genuine paradigm shift. The major facets of the paper:
- Show that some of what was once called alpha can, in fact, be captured as beta
- Develop a broader framework for thinking about returns, adding an implementation strategy dimension to the traditional asset class definition
- Examine the diversification properties of some of the new — or so-called “alternative” — betas that come from this broader framework, and
- Consider implications for alpha and beta.
But smart beta remains contentious. For instance, Phil Tindall of Towers Watson in London, delivered a presentation last year to a CFA conference in Amsterdam, where he lined up a couple of famous names on either side of the debate. Tindall quoted Rob Arnott of Research Associates as saying: “If one could find a more reliable alpha, and pay less for it, that would be pretty smart”. And Cliff Asness (founder of AQR Capital) saying: “Smart beta: not new, not beta, still awesome”. On the other hand, he quoted the aging stalwarts, Jack Bogle (founder of Vanguard) saying: “What the devil are they talking about when they say smart beta?” and Nobel Laureate Bill Sharpe: “When I hear ‘smart beta’ it makes me sick”.
For investors, the big thing is that what they may consider “pure alpha”, and therefore pay a lot for in terms of fund management fees and transaction costs, can actually be classified as “beta” and therefore both more consistently achieved and achieved at a lower cost.
But Towers Watson does not rock the boat as much as it could. By coming up with the term ‘bulk beta’, it allows managers to charge at least some premium for the smarter variety, even though, with technology, it is doubtful there would be significantly higher costs involved in delivering smart beta. Isn’t it just another factor algorithm and a little more work for the custodian? In fact, couldn’t the custodian do the whole job? It’s no coincidence that two of the big custodians, State Street and Northern Trust, are also reaping a lot of the benefits of the smart beta trend through their investment management arms.
Anyway, the Towers Watson paper concludes that beta needs to be considered in a broader framework than previously. It’s not just about market returns (bulk beta), it’s also about all the asset classes and sub-classes which are exposed to common risks or other factors. It requires some skill.
Therefore, the flipside is that some alpha is actually beta. Therefore, appropriate (lower) fees are in order. The new definition of alpha, according to Towers Watson, is: “returns that cannot be explained by exposure to common risk factors”.
– Greg Bright