In its latest comment on sectors, Moody’s Investors Service, reports on the rising phenomenon of smart beta and predicts it could lead the way to challenging traditional asset managers. ‘Smart Beta 2.0: The Next Battleground for Asset Management Dollars Heats Up’ finds that asset managers are accelerating their expansion into the smart beta space, as alternative index strategies become more sophisticated and gain broader market acceptance. “Just this week, OppenheimerFunds announced its agreement to acquire smart beta-focused investment firm VTL Associates, BlackRock (A1 stable) launched three multi-factor ETFs and Vanguard hired smart beta specialist Denis Chaves from Research Affiliates” the firm writes. The increasing popularity of smart beta will benefit two types of firms that are assuming leadership roles and are well-positioned to take advantage of this trend, according to Moody’s. One set includes BlackRock, State Street and Vanguard, large asset managers that can make use of their scale and extensive quantitative research and product distribution capabilities, while the second set includes model-focused and theme-oriented innovators such as Guggenheim, WisdomTree, Research Affiliates, AQR and DFA. The innovators are willing to take differentiated approaches accessing non-traditional betas or generating true alpha, Moody’s says. “These firms accept the performance risks associated with diverging from the benchmark indices, and are comfortable with developing products with concentration risks as well as utilising techniques such as market timing, factor rotation, and factor timing.” Moody’s notes that, over the past year, several of these firms have made substantial investments in smart beta, including through acquisitions. “In the race to establish leadership in the next phase of smart beta’s evolution, BlackRock, for one, has invested heavily in its quantitative active equity capabilities, and in June hired Andrew Ang from Columbia University to lead its factor based strategies group. Newer entrants have either launched products or made acquisitions to acquire expertise in the space this year – examples include Legg Mason’s (Baa1 stable) acquisition of QS Investors, NASDAQ’s acquisition of Dorsey Wright and Victory’s (B2 stable) acquisition of Compass EMP,” Moody’s writes. Meanwhile, other firms such as Franklin Templeton (A1 stable), have expressed interest in establishing a presence in smart beta. “We believe that capital investment into smart beta product development is likely to continue at a robust pace. This accelerating activity has coincided with a shift in the evolution of smart beta products from the basic – simple and static security selection and weighting schemes – towards the development of more sophisticated products that are based on multiple factors and timing of exposures.” The next phase of smart beta, entitled ‘smart beta 2.0’ by Moody’s, will, it predicts, be more focused on research. “This next phase will likely place smart beta funds in direct competition with traditional mutual funds, given that future smart beta strategies will not only use multiple factors – such as quality and value – but will also incorporate decision-making processes to determine and actively adjust a fund’s level of exposure to different factors and betas,” the report says. Smart beta 2.0 will evolve into a more disciplined and cheaper form of active management, taking on the goals of traditional active managers, but at a lower cost and with more consistency in terms of adhering to a set of investing rules. The firm predicts that at the current growth rate, smart beta’s impact on traditional active management could be significant. “Traditional active managers are likely to be forced to further compete on price. Additionally, asset bases could be at risk from managers who cannot differentiate themselves by performance or other services offered to clients. Those most at risk are traditional mutual funds with highly diversified portfolios whose performance closely tracks, and typically lags, the index – e.g., closet indexers with over 100 securities in their portfolios. The AUM loss from these firms could directly accrue to asset managers well-positioned to offer the next iteration of smart beta funds” Moody’s warns. In conclusion, the firm finds that though the pace of smart beta’s development has been fast, the market is still quite nascent. “Hurdles in the face of future progress remain, and include the risk of poor product development leading to funds that fail to generate attractive returns or correlate too closely with traditional indices. Another challenge asset managers expanding into smart beta will face is in setting fees, which, if not materially different from traditional active managers, could also pose a hindrance to investor acceptance.”
Moody's reports on the increasing popularity of smart beta. It predicts the next phase of smart beta products will incorporate decision-making processes and have a greater focus on research. Moody's sees the sector evolving into a more disciplined and cheaper form of active management which will place smart beta funds in direct competition with traditional mutual funds. Most at risk are closet indexers with highly diversified portfolios and firms which cannot differentiate themselves by performance or other services.