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Why smart alpha is the cure for passive management problems

By Guest Author

Thu Oct 15, 2015

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There is a reason for the adage “you get what you give.”


Mazin Jadallah, founder and ceo of AlphaCloneBy Mazin Jadallah

There is a reason for the adage "you get what you give." It’s true. Across most facets of life, actively pursuing goals and taking risks reaps reward. Investing is no different. While passive management is often seen as beneficial because it’s a low cost, low governance strategy, there are a number of other factors that need to be considered when deciding if you want to go passive or active. 

It is widely held by some of the most experienced investors in the market that returns across major asset classes are forecast to be drastically lower than they’ve been in the past. Jeremy Grantham recently published GMO’s seven-year forecast for major asset classes. It’s not pretty. Projections for equities and bonds are negative with the exception of emerging markets. Compare this to historical average annual returns of 6.5% for US equities.  

In addition, KKR recently published a great graphic ( exhibit 54) to put the performance of the S&P 500 over the past several years in context.  If the index delivers a positive return this year it will be only the fourth time in history where it has generated more than six years of consecutive positive returns. 

The upshot of all this is that an investor who wants to invest passively must either save/invest more, work much longer, make do with less when they retire, or worse, all of the above essentially defeating the point of long-term investing. 

Another problem with passive asset allocation is that the approach fails to factor in behavioral risks. There’s no contingency to hedge or protect capital during market disruptions. Anyone who has lived during a financial crisis knows how difficult it is for investors to not act on their fear and potentially sell at the wrong time.  Seeing great long-term returns illustrated on a piece of paper is one thing. Living every minute of every day during repeated market turbulence is another entirely.  Investing is emotional, and simple passive allocation does nothing to address this.  Behavioral risks are real and occupy the thinking of even the most experienced investors

Robo advising as a remedy

Some think computers controlling your portfolio is the answer. Robo advisers are poised to go mainstream in the next three to five years, according to consulting firm A.T. Kearney. And why shouldn’t they? After all, they're making investing simpler and cheaper vs traditional advisors, and they’re a shining example of the Uberization of finance—cutting out the middleman. In robo advising, every investor has an optimum portfolio that maximizes returns for every unit of risk. Additionally, the investor can benefit from variances that further optimize performance. 

While robo advising has made simple passive asset allocation cheaper, it doesn’t address the important shortcoming of lower forecasted asset returns and the all too real behavioral risks which active approaches can often help with. Even Jack Bogle, the father of passive investing agrees that an investor seeking the average return of the market at a lower price must also accept those returns for "better or worse."

Smart Beta as a remedy

Amid the passive management revolution, the smart beta investment strategy is also an option. This approach aims to beat the market by passively following more sophisticated indices. In these cases, the investor can allocate to a passive rules-based investment product that seeks to do better than the overall market as represented by a market capitalization weighted index. 

Smart beta products alter the method in which securities are weighted inside an index. Some will weight securities equally. Others will weight them based on a company's fundamentals or the amount of dividend it pays. 

While this strategy sounds winning, the reality is that investors who want to take advantage of smart beta products are actually making an active investment choice around which exposure to buy and in what proportion. They are expressing an active opinion that, for example, small capitalization stocks will outperform large capitalization stocks or that momentum stocks will outperform value stocks. Smart Beta has simply transferred the active bet from stocks to passive products.  With more than 350 smart beta funds trading today, according to ETF.com, up from 212 last year, Smart Beta does little to solve the selection dilemma for long-term investors.

The Smart Alpha solution: Man and machine

Active selection, whether it be via stocks, mutual funds, ETFs, or hedge funds, can be daunting because of the nature of how investment decisions work (backward looking evaluation, performance chasing), and the irony of lack of access to some skilled managers while still being faced with thousands of choices. We call this the "tyranny of choice dilemma."

But what if there were a way to solve for this dilemma of access and choice? Institutional investors and hedge funds are required to disclose all their long positions quarterly to the SEC in Form 13F.  The form allows any investor to view where a particular manager is investing and when analyzed properly can also give the investor a view of whether the manager has demonstrated any stock selection skill. Evaluating a manager using its disclosures can be much more powerful than any due diligence of the manager’s actual returns. 

Think about it: a manager’s actual performance can come from many sources, including the use of leverage, market timing, trading skill and, of course, the manager’s selection skill. This makes it practically impossible for most investors to identify exactly what has driven performance for the manager. On the other hand, "cloning" a manager’s holdings based on their filings lets us strip away all potential sources of returns except the most important one – manager selection skill.  At AlphaClone, we call this "Clone Scoring" and it is at the heart of how we select managers that make it into our strategies. 

Analysis of institutional holdings via Form 13F can give investors an elegant way to solve for the problems of access and manager selection in active investing. By offering these strategies in ETF form, investors can also benefit from the best of passive investing. ETFs can give investors material advantages over mutual funds, hedge funds or separate accounts. They use rules-based portfolio construction and hedging, are 100% transparent, are relatively lower cost, and are accessible to everyone. They are also tax efficient.  This new breed of "strategy ETFs" leverage the power of both man and machine to increase the potential for investors to achieve their investment goals. We call it "smart alpha."

Think of the smart alpha approach as a self-driving car for your investment journey. It can drive, select and alter the route you take, and avoid risks on the road in order to get you to your destination safely, quickly and relatively cheaply. For the long-term investor, we believe this is the smartest vehicle to ride.

Mazin Jadallah is the founder and chief executive of AlphaClone, a San-Francisco based registered investment advisor and equity research firm that offers investment products and solutions derived from institutional investor public disclosures.

ISSN: 2151-1845 / CDC10004H



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