At the 2015 Inside ETFs conference, held in Hollywood, Florida, in late January, exchange-traded-funds market participants, thought leaders, investors, entrepreneurs and general investing enthusiasts collectively wrestled with the ideas and trends setting the stage for what’s to come in 2015.
One theme that rose to the top — with three dedicated panels, including a panel on which I participated — was the developments surrounding smart beta and passive investing. During these discussions, we attacked the challenges and opportunities of this growing investment concept, particularly in regard to how this strategy will be received by investors and their advisers in the year ahead.
Struggling with grasping how to deploy a smart beta strategy is one thing. But when it comes to creating a working definition of smart beta on which the entire industry can agree, we’re stuck at introductory-level courses.
I see smart beta at its core as a strategy built on the melding of risk adjustment and return enhancement. With these two core concepts, investors can more readily identify and express both their short-term views on the market and their long-term goals and objectives, while increasing diversification and the overall risk-adjusted return for their portfolios.
Let’s look at a real-world smart beta example: the pension funds industry.
At the conference, we heard a lot about pension funds showing a consistent evaluation of the actively managed portions of their funds. With smart beta straddling the line between active and passive, some asset owners are considering moving more assets away from expensive, underperforming active strategies. Certainly, then, the attraction of the smart beta space becomes that much more acute.
These pension funds need to find pockets of performance within a broader market, ones in which performance is not hard to come by. Cost becomes more of a drag on the portfolio if the performance is not there, however, and that’s why we’re seeing a trend among institutional investors of ongoing, constant evaluation of the actively managed portion of their portfolios. Still, today 60 percent of large-cap active managers can’t outperform the stated benchmark, and that drives pensions away from active management and toward more passive vehicles. Smart beta can benefit from toggling between active and passive management in a rules-based, transparent index. The consensus is that we will continue to see this trend perpetuate, as costs increase and the challenges facing pension funds continue to evolve.
Regardless of how we as an industry debate the definition of smart beta and its deployment, the reality is that it’s here to stay. In 2015 we will continue to bridge the knowledge gap of what these smart beta strategies are and how are they implemented. For the time being, though, we need to recognize that there’s a continuing need for better education and support for the majority of institutional and retail investors alike, as they consider incorporating smart beta into their portfolios.
Robert Hughes is vice president for global indexes at Nasdaq OMX Group in New York.
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