We interviewed Tolu Osekita, Investment Director, InvestFord Group for the Smart Beta Investing, Europe 2017 report; What are the benefits of multiple Smart Beta strategies for portfolio diversification?

Ben McNamara, Content Publisher, Clear Path Analysis: How do you define it and what has been your experience with Smart Beta?

Tolu Osekita: I’d define ‘Smart Beta’ as essentially any alternative to market cap weighted indexing for markets that are proving increasingly inefficient.

Beta investing has been around for a very long time and is based on the fundamental premise that markets are efficient. So, therefore, share prices reflect a company’s intrinsic value. We all know that’s not the case and active investors have sought to exploit these inefficiencies to generate Alpha.

So ‘Smart Beta’ is essentially a smarter, rules based, systemic, cost-effective way to invest passively in efficient markets.

The second part of your question was around my experience with Smart Beta. That was predominantly borne off the back of the last financial crisis in terms of higher correlation among asset classes and an obvious schism between the fundamental drivers of company performance and their share prices. Central bankers and geo-political events became the most major drivers and introduced higher levels of unpredictability, or – if you like – inefficiency.

With over 20% of the portfolio for which I was responsible, I invested passively in equity markets, this increased, uncontrolled volatility and the subsequent impact on returns and funding levels worried me. Add to that the impact Quantitative Easing (QE) was having on asset prices, and the fact no one had any real idea how things might respond when the inevitable unwinding starts, well, something needed to be done about minimising volatility whilst still generating better, risk adjusted returns. That led me to Smart Beta.

Multiple Smart Beta strategies give you more tools or levers to help achieve what can sometimes seem like conflicting investment objectives within your portfolio. It gives you the tools to, in a cost-effective way, maximize risk adjusted returns whilst minimizing your risk which is what every investor wants.

Ben: In your experience, for those who are new to Smart Beta and unsure about it as a tool, how do you approach Smart Beta before considering the options that are available in the market?

Tolu: A healthy dose of scepticism is never a bad thing in an investor - especially when there is a proliferation of products professing silver bullets that would resolve all one’s problems!

Having said that, for me, the starting point is always to ask what the ultimate objective is? What am I looking to achieve? What exactly is the problem I’m looking to solve? As I said earlier, for me at the time, it was smoother risk adjusted returns in my equity portfolio (a large percentage of my overall asset allocation).

Specifically, around Smart Beta, the perspective one is coming from is also important i.e. are you looking at your portfolio through your active strategies or is it from the passive perspective? By this, I mean, are you looking at your active managers and feeling that they aren’t performing as they should (and so you want to take a more systemic approach to doing things), or are you looking at your passive portfolio and thinking that you don’t like the level of volatility and lack of control that you have and so would like to put more control in.

These are all considerations that most investors have on a daily basis regardless of how sceptical they are, as long as they are invested in equity markets. And then the ‘so what?’ question (i.e. ‘so what are we going to do about all these considerations keeping us up at night?’).

Do you want to buy a bog-standard solution off the shelf and go with some manager that you know, or who has made a very good presentation to you, or have you though deeply about how your portfolio is currently constructed, what your views are on the environment in which you are investing, what your liabilities are and the expectations that you have (and then think about how you want to meet these)? These are the fundamental questions that you need to consider.

Ben: What are some of things that investors don’t necessarily understand about Smart Beta?

Tolu: Over the years, Smart Beta has been made to look increasingly complicated and a lot of the blame for this has to lie with solution providers who are under pressure to differentiate their products in order to maximise sales.

It’s important to keep a focus on the basics, the fundamentals. In this case, this is essentially ‘passive investing’ – albeit in a slightly smarter way! The proof is (and should be) in the name: “Smart Beta”, it’s not “Smart Alpha”.

It’s not a subjective, skills-based approach to generating above market returns. There should be nothing fancy or complicated happening in a black box somewhere. It is objective; it is based on simple rules and should therefore also offer low-cost market access.

Keeping things simple and focusing on the primary objective that one is looking to achieve makes it easier to navigate and find the solution that best fits.

Ben: Once you have simplified it (and have it clear in your head as to what you want), how do you then develop a robust Smart Beta strategy?

Tolu: There are several considerations, and these include taking a robust look at your overall portfolio. Most investors have broadly diversified asset allocation, say something like 60/40 equities to everything else.

Within that 60% equities allocation, there are likely to be different styles and markets that you are invested in, with different equity factors or strategies trying to generate returns over different cycles. A basic understanding of what’s in that equity portfolio is a good start, coupled with a clear idea of the investment objective which in my own case, to remind you, was smoother, risk adjusted returns.

Once you have an understanding of the underlying portfolio that you currently have, you can then make decisions on how best to pragmatically achieve your objectives, paying particular attention to correlation and being conscious one does not overly increase exposure to any unwanted or already concentrated equity risk factors.

Ben: Why would you create a multiple Smart Beta strategy? What is the benefit to this from an investors point of view? If they start with one Smart Beta product, why expand it into a multiple Smart Beta strategy?

Tolu: A multiple Smart Beta approach gives you several levers to play with in managing your portfolio, and that’s almost never a bad thing. For me, I wanted better, risk adjusted returns whilst minimising volatility. One could argue that is tantamount to wanting to eat my cake and have it, but hey, it was what I wanted to achieve and what I felt was possible.

I could have picked any single, equity risk factor (size, value, momentum, and volatility, or whatever) and based my Smart Beta allocation on that singular factor. That may mean I only achieve one of my two key objectives; say lower volatility but poorer, below market returns, or I might generate better than market returns but with what would have been unacceptably high volatility.

Having these slightly conflicted objectives is what led me to start thinking about how we can blend a combination of different factors to achieve a more balanced portfolio. For me, this flexibility is the key benefit of a multi factor approach because (more often than not) you will have slightly conflicting objectives that you are trying to achieve, and one factor isn’t necessarily going to give you everything you want.

There is often no silver bullet, so it comes back to the idea of risk and control. With share prices becoming increasingly detached from fundamental company performance, increased volatility from geopolitical or macroeconomic factors, including QE, the shortening (and lengthening) of normal market cycles, it’s increasingly difficult to gauge how one equity risk factor will sustain returns over time. That makes a multiple Smart Beta strategy very attractive for most investors.

Ben: How do you develop that comprehensive strategy to limit risk in a cost-effective way? Some investors move to Smart Beta because it is more cost effective than having an active management approach; but if you have a multiple Smart Beta strategy to limit the risk, doesn’t that negate the cost efficiency?

Tolu: Yes and no. It is interesting because a lot of investors fall into two broad categories, those who are moving away from Active Managers and into Smart Beta, and those who are moving from passive, market cap weighted indices into Smart Beta.

The view of costs from these two opposing perspectives will be different, but if you are coming from the active side and are paying 50-70 basis points for an active strategy, halving that without a marked drop in performance represents good value.

If you are coming from the passive side of your portfolio and are paying 10 basis points for a market cap weighted tracker, then you don’t really want to pay more than double that for the additional tools or levers a Smart Beta strategy gives you. Anything north of that probably doesn’t give you any real, net of fees value.

Personally, my view of costs and fees stems from looking at it from the passive side of things, so Beta with 10+ basis points as a benchmark as opposed to approaching it from a 70+ basis points perspective.

In terms of trying to minimize the costs, the fact that you are trying to blend multiple equity factors would probably mean paying more than one index provider, hence a slight increase in costs. However, given the fact that index costs are dropping on an almost daily basis (you can buy most indices for less than 5 basis points), so a blend of two or three would add up to circa 15 basis points, add whatever manager resource (including the transaction costs of rebalancing on a bi-annual basis or something along those lines), that would add another circa 5 basis points to make it 20 in total.

And as I said previously, that’s probably double the circa 10 basis points most investors pay for the traditional, bog standard, market cap weighted indices (albeit with potentially much lower volatility and better risk adjusted returns).

Ben: How do you prevent a multiple Smart Beta strategy from becoming too complex (because these are ultimately quant products)?

Tolu: That’s an excellent question and comes down to establishing from the start what you are looking to achieve; for example, minimizing volatility, maximizing returns, being more defensive or whatever. The rules need to be set from the get go in line with the investment objective, including how often there’d be any intervention like rebalancing (not more than 4 times a year at most, so as not to inadvertently become ‘active’ and, consequently, end up racking up transactional costs).

Ben: You mention not intervening more than a few times per year. I am assuming that the relationship with the manager and provider is crucial to this. What relationship do you need to develop with your manager when working with Smart Beta to ensure success?

Tolu: The relationship with the manager is absolutely critical. You want a manager with robust infrastructure (including information systems, operations and risk processes), a transparent investment process (ideally with an integrated investment platform), as well as strong relationships with the major index providers. It goes without saying that good client interaction where any issues can be sorted out quickly is key as well as very good reporting capabilities.

Ben: Thank you for sharing your views on this topic.

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