With the help of record flows into index funds in their various forms – smart beta, RAFI funds, scientifically designed funds, high frequency trading funds and good old-fashioned market-cap indices-matching funds – you would think that this would be a stock-picker’s dream. But it’s not, yet.
Simon Savage, director of alternative beta at Man Group, prefers not to think of these market-driven tilted index strategies as beta, though. He thinks of them as “liquid large-scale low-cost alpha”.
Savage, who spent 12 years at the discretionary active side at Man Group as a long/short manger before taking on his current role, said on a visit to Australia last week that each year, it seems, the amount of index tracking investing goes up. “So, surely, you would think, it gets easier for active managers to beat the index. But, each year that has failed to materialise in their peer group performance numbers.”
The funds management industry loves its jargon, particularly in emerging popular strategies such as smart beta. But, as Savage says, “risk premia, factor investing and alternative beta” are all pretty much the same thing.
An interesting development, though, is the use of artificial intelligence in investing, both in terms of gathering market information and in terms of more efficiently implementing decisions.
“If there is less human decision making in the future,” he says, “will we still see the same anomalies in the market that we’ve seen in the past? I don’t think you can say with any certainty that the factors we know now will be there. They are not a fundamental force of nature. We’re not talking about gravity.”
But, on the other hand, human beings would continue to have an impact on markets for the foreseeable future, he said. “They will be making decisions somewhere… But it may not be in the same places as we have seen over the past 50 years. Computing is changing the market.”
Factor investing is not as simple as it seems. For starters, factors – such as value, low-volatility, quality, size and momentum – all have their own cycles. Picking those cycles is just as difficult as picking what asset class will be the next to outperform.
Also, according to Savage, there is a big range of outcomes from different indices which attempt to measure the same factors. If you were to choose a European value ETF, for instance, you would fins that the several products available had different methodologies and different risk/return profiles. However, Savage says, it’s still at least 90 per cent of the return which is due to the “market”.
While the past may not be a great guide to the future performance of factors, Savage says that investors should look at how discounts to the market have behaved in the past. For instance, if a Malaysian bank trades at a discount to an Australian or US bank, investors should study how it has behaved in the past and what influences are possible to close the valuation gap in the future.
“Sometimes things are reassuringly expensive. Maybe the price reflects the quality of the asset or service,” he says, both of stock prices and manager fees. With respect to fees: “If skill is scarce, if there is limited access, if the strategies are complex, then managers may be able to justify charging a higher price for their services.”
Savage says there are three layers of costs in terms of strategy implementation: explicit, implicit and hidden. ‘Explicit’ includes easily identifiable things such as commissions and settlement costs. ‘Implicit’ includes things such as market impact and the bid/offer spread. ‘Hidden’ costs, which have only emerged in recent years due to computerisation, include things such as high frequency trading interference, pre-trade movement impact and “signal gaming”.