The Smart Beta

Passive products like exchange traded funds are a relatively new sector to India. It can increase market size and enhance financial infrastructure

In case you missed it, the Bloomberg Businessweek cover leveraged the male anatomy to make a statement about hedge-fund returns. Though catchy and good for sales, the cover evoked a mixed response and a few considered it was in bad taste. The social mood is so much about jailing bankers that hedge funds should be happy being just derided on covers. The society, like nature, is about extremes, it goes all the way from praising to trashing. We can now draw a four-stage product cycle for hedge-fund success and failure, but active money management also goes through seasonality.

According to The Economist, Smart Beta is a new passive investing approach with more than a 100 billion tracking it compared to about two trillion tracking other passive styles. The Smart Beta’s idea is to enhance returns tracking an asset. Skill and judgment come under test as quants take over. This is the new age of indexing, the commoditisation of alpha and beating the index.

This is some innovation, but why did this take 150 years for passive indexing to wake up. The key reason is the competing active versus passive broad styles. Markets have gone through a succession of crises, in 2000, 2002 and 2008. Investor and consequently regulatory perception has gone through a sea change. Investor psychology judges the worth of active money management differently. Active could not outperform passive as the markets whipsawed, delivered negative returns for a decade. There was a lot of anger against active money managers as they failed to match expectations.

More, index innovation only caught after 1984 when index futures were launched and sector innovations and inter-market perspectives gained ground in 1990. Active money management also had a decade of secular upside. In a secular upside, outperformance generally goes unnoticed, as cash gets conserved and money is made. Profits lead to complacency. It's the losses that cause panic. So, it was not that active always outperformed and it was right to praise hedge funds and active money management earlier and now trash those. It's that we did not have measures to quantify and segregate performance parameters earlier. Even the history of performance was brief. The profit-loss psychology also distracted us to notice active performance earlier and enabled us to notice it now.

So, calling the money management business broken is simply a perception. As the Simon bounds of rationality enlarge, we will keep trashing the same models we worship. This is the process of innovation. Even 'Smart Beta' or 'Fundamental Indexing' we acknowledge today could be considered a continuing attempt in alpha innovation tomorrow. Cut down the management fee and enhance alpha more than the universe and you are flanking a $2 trillion business. A few $100 billion are bound to filter down to such new approaches.

And like behavioural finance highlights how benchmarking could be an unethical exercise for active money, choosing a benchmark that shows a fund performance in a better light, even the current passive model has more hurdles to cross before it can claim to become the “market” itself. What should the "new age passive" achieve? Standardisation; passive models cannot just be asset or region specific. They should work across markets and regions. Universality; passive models should not go into the blind elephant loop, claiming their approach better than the rest. The aim should be to see the elephant rather than glorify parts of it. Outperformance should be conspicuous and contrasting rather than an enhanced 100-200 basis points piggybacking on an attractive low fee framework. In the end, active and passive style demarcation should not be a sales pitch but a differentiation linked to risk-profiling.

India, owing to its lagging financial sophistication and a growing community of financially-aware educated middle class, has an opportunity to learn, adopt and adapt. Passive (products like exchange traded funds) is a relatively new sector for India, which can increase market size and enhance financial infrastructure. But before we reach to a new passive, we have to understand that risk-adjusted active products are the old passive.

The author is CMT and founder, Orpheus CAPITALS, a global alternative research firm