With investors almost euphoric in their love of index funds, it seems that every active manager is looking to smart-beta, or factor, investments as the antidote. But Goldman Sachs Asset Management is banking that its 17 years in the discipline will give it a strong foothold in this hybrid of active and passive investing, which may define the industry over the next decade.
New York–based GSAM made strategic beta available for the first time in an exchange-traded fund format when it launched its ActiveBeta ETFs last September. The lineup has since gained $2 billion in assets. GSAM has more ETFs in the works, including a small-cap product that may be launched by the fourth quarter.
Smart-beta investments — which also go by names such as strategic beta, engineered equity and multifactor and are typically priced midway between a generic index fund and an active one — grew out of academic work in the late 1960s and early ’70s that isolated factors and attributes of stocks that would lead to outperformance over a market cycle.
Researchers studied the returns of value managers, for instance, to determine how much resulted from a stock picker’s individual talents versus market factors that a formula could replicate. The work of Eugene Fama and Kenneth French, finance professors at the University of Chicago and Dartmouth College, respectively, and their three-factor model to describe stock returns were the catalyst for much of the thinking behind strategic beta.
GSAM developed its first smart-beta investment, focused on providing maximized aftertax returns, in 1999. In 2008 the firm launched its Absolute Return Tracker Fund, which simulated hedge fund drivers of return; three years later it created an alternative-equity index with Standard & Poor’s that combined lower volatility and value stocks. In 2014, GSAM acquired Boulder, Colorado–based Westpeak Global Advisors, which offers smart-beta investments based on such factors as profitability, momentum and low volatility.
Although it’s only one part of GSAM’s $50 billion in smart-beta investments, the firm made a surprising move with the rollout of the ETF lineup last fall. It kept the ETFs’ price tags similar to those of market capitalization–weighted index funds, which can charge less than 30 cents for every $100 managed in U.S. and developed-countries strategies. “We didn’t want price to be a factor when investors weigh the benefits of our products with those of market-cap index funds,” says Timothy O’Neill, GSAM’s global co-head of investment management.
GSAM also wants to take a big chunk of the market cap–weighted index fund market while the smart-beta business is still fairly young. As of December 2015, assets in U.S. index mutual funds totaled $2.2 trillion, according to Washington-based industry group the Investment Company Institute.
Gary Chropuvka, head of the GSAM unit that includes customized beta, alternative-investment and tax-advantaged core strategies, says the firm has concentrated on identifying the risk premia — yet another term for smart beta — in the portfolios of pension funds, endowments and other institutional investors.
As part of that process, GSAM determines what factors an institution might have too much of — say, an overexposure to momentum, creating unnecessary risk — and where it may be underweight. It also analyzes the work of active managers to discover if they’re contributing something beyond a systematic factor. “Active managers should add value that clients can’t get from more common places,” Chropuvka says. “One of our jobs is to observe if they are doing that.”
GSAM isn’t the only manager with a long history in smart beta. Among those with robust track records are AQR Capital Management (before co-founding Greenwich, Connecticut–based AQR, Clifford Asness was GSAM’s director of quantitative research), Northern Trust Asset Management, PanAgora Asset Management and State Street Global Advisors. Dozens of other firms are getting into the market.
Given increased scrutiny of hedge fund fees, GSAM’s biggest opportunity may be in replicating so-called hedge fund betas. “We believe in the return-generating ability of hedge fund managers, but we also think there are systematic factors that explain a fair amount of hedge fund returns,” Chropuvka says.
Eric Nierenberg, director of hedge funds and low-volatility strategies at the $60.6 billion Massachusetts Pension Reserves Investment Management Board (PRIM), hired GSAM last year for an alternative-beta mandate. In the mid-2000s as a graduate student in economics at Harvard University, Nierenberg did behavioral finance research on why risk premia exist in the market. “Part of the reason I came here and was hired was I felt we need to be naturally skeptical of hedge fund strategies because of the very high fees they entail,” he says. “We also need to rethink the way we assess whether hedge funds have skill.”
On Nierenberg’s recommendation in 2013 that the board consider hedge fund betas and develop a framework to assess its managers’ returns, the Boston-based PRIM added a $600 million allocation, called portfolio completion strategies, for alternative beta and a few other investments, including direct agriculture.
Smart beta presents challenges for asset managers. One fear is that factor-based funds will become a commodity and a business dominated by a few players, much like cap-weighted index funds. There’s also concern that, in the race to find new factors, some asset managers will start data mining, identifying correlations in historical data that won’t bear any fruit.
Smart beta is fertile ground for active managers threatened by inflows to passive strategies. But as such funds proliferate and get better at delivering existing and not-yet-known factors, they make life even tougher for those managers, who will have to invest heavily in new techniques to generate returns.
“Many things that start out as alphas become betas, even in our daily lives,” GSAM’s Chropuvka says. “When I got out of college 25 years ago, knowing how to do an Excel look-up command on an area of data was alpha. Now every single kid coming out of school knows how to do it. That’s beta.”
