SMART BETA AND THE POWER OF LANGUAGE

Have you ever thought of the perfect retort, but only done so too late to actually use it? The French have a phrase – l’esprit d’escalier (literally, the wit of the staircase) to describe just this predicament, yet we don’t have an obvious equivalent in English. In a similar vein Korean has a word, nunchi, to describe the intuitive ability to gauge how people are feeling, and to know what not to say. Angdai, in Hindi, refers to the lazy morning stretch you do when you wake up in the morning. However my favourite word that English could really use has to be the Scottish word tartle – the awkward feeling of having to introduce someone whose name you can’t remember.

The trouble is, without these words, it’s much, much harder to express certain ideas - it would be like trying to study medicine without the terminology. You can be as clever as you want; without the right words, it takes much longer to express an idea, and sometimes you simply don’t have the means to express it at all. At a more general level, if the tools at your disposal are limited, then so are your outcomes. This is where it becomes relevant for investments.

A classic financial example of the power of language is smart beta, or alternative beta. As an investor, you may well have to take a certain amount of equity risk; you may choose to take some equity alpha as well, to diversify your sources of return. You might have a good sense of the different asset allocation approaches your managers use, and be skilled at selecting appropriate managers; but without the ideas and even just the terminology, you face a number of disadvantages[1]; crucially, you would have to use more words, and in an investor’s case pay higher fees, to get the same results.

As I argued in a previous post, if a manager’s performance is consistently better, they are probably doing something consistent. I’m not arguing that there isn’t any alpha to be had; however a lot of what has been considered alpha can be replicated mechanically. This means that strong outperformance over the benchmark can be achieved at substantially lower cost. To put this in some perspective, we compare the performance of the MSCI World with an equal-weighted basket of three long-short equity style premia[2], based on Deutsche Bank’s style indices. As a very crude proxy for an alpha benchmark, we also show the performance of the HFRX Global Hedge Fund Index.

These styles have shown pretty dramatic outperformance. However, as a fundamentally mechanical, smart beta product, these styles (across asset classes) can be accessed for much lower fees than traditional alpha. For a fund targeting 10% volatility, you might pay 70-80bps; that means, very roughly, that the price for the basket shown is about 35bps (investing 40-50% in a 10% volatility fund and 50-60% in cash). This clearly compares favourably to the 40-80bps one might pay for active management, or even the 2 and 20 one might pay for a hedge fund [3].