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Smart Beta Doesn't Need to be so Passive

By Crucial Clips     July 27, 2016
The following text is a transcript of a portion of a speaker's presentation made at an industry conference or during an interview. This transcript solely represents the view of the individual who spoke, and not the view of Financial Advisor IQ or any other group.
Source: FA-IQ, Jul. 12, 2016 

BRUCE LOVE, MANAGING EDITOR, FINANCIAL ADVISOR IQ: This is Bruce Love with Financial Advisor IQ, and I’m here with Paul Bouchey, CIO of Parametric. Paul, what’s the problem with smart beta?

PAUL BOUCHEY, CHIEF INVESTMENT OFFICER, PARAMETRIC: Well, I think that smart beta is fine as far as it goes. It’s part of the movement of the indexing trend that we’re seeing. And I think it’s a real threat to active managers in the industry. It’s providing an active investment exposure at very low cost and at high transparency.

But there are some issues. These indexes have higher turnover than your typical market index. And that can come with extra transaction costs. And for taxable investors, it can come with a higher tax bill as well.

In addition to those turnover-related issues, there are also some unintended active bets can be embedded in these indexes. So if you’re in a value index or an index like that, sometimes you can pick not only inexpensive companies, but companies that are unprofitable as well, or maybe have a large overweight to energy stocks in your portfolio. These kind of unintended risk exposures are what we’re concerned with at Parametric. And when we design these smart beta and factor strategies, we try to control those unintended exposures and make the transaction costs and taxes palatable.

BRUCE LOVE: What exactly do we mean by smart beta when we’re talking about the grander scheme of passive investments?

PAUL BOUCHEY: There’s a spectrum. So pure beta indexes would be market capitalization-weighted, so a passive snapshot of the market. There’s smart beta indexes, which can be implemented as exchange-traded funds or in a separate account. And those tend to be different weightings. And it could be equal-weighted strategy or some other value-based strategy.

And then finally, there’s a set of strategies coming out more recently associated with factor premia. And these are targeting specific risk factors, like value, size, momentum, profitability, and so forth. And those are targeted to outperform the market in the long run. And sort of that spectrum of different weighting strategies, different factor exposures-- those are the kinds of different smart beta approaches that we’ve seen.

BRUCE LOVE: So how are they constructed, and how much do they cost compared to, say, other passive strategies? They seem-- they have a little bit of active management involved in them.

PAUL BOUCHEY: Yeah. There’s a broad range. But typically, they’re going to be between 5 and 15 basis points over and above a pure passive exposure, depending on the strategy.

BRUCE LOVE: So what are the sorts of problems that advisors get into using smart beta in their client’s portfolios?

PAUL BOUCHEY: Well, I think that people have been trained by the ETF industry to do a very minimal amount of due diligence on strategy. So if you’re picking a purely passive index, you can just say-- you can just look at the title of the fund-- it’s the U.S. large-cap ETF-- and then you look at the expense ratio, and that’s really all the due diligence you need to do for a pure passive kind of fund exposure.

But for a smart beta index, just reading the U.S. large-cap momentum fund is not enough due diligence. You need to understand how the fund is constructed, what the underlying turnover is. And I think advisors and investors should really treat these as active strategies and give them the proper due diligence.

BRUCE LOVE: Paul, thank you very much.