Smart Beta Reduces Equity Dependence

In Global Investment Matters, an annual publication from Towers Watson, the company suggests diversity through smart beta can help manage risk, while implementation of the ideas behind it allows investors to exploit competitive advantages. In addition, it asserts that many institutional investors will have to hold risky assets for longer than expected in order to generate required returns and that smart beta would be a good way to reduce dependency on equities while doing this.    

In the article, titled “Long-Term Risk: Get Smart (Beta),” Towers Watson disputes the common thesis that equities are good for the long run and suggests that while diversification has been a textbook answer to the problem of risk concentration, it has also increased complexity for investors. It suggests that smart beta ideas embody a number of concepts that improve on traditional approaches to diversification. The article reveals that the historical return pattern for a combination of smart beta strategies compares favorably to global equities, while acknowledging the period used for the comparison was a difficult time for this economically sensitive asset class.  

The article asserts that the implementation of smart beta ideas as diversifiers may not be for everyone but suggests some investors have the potential for a competitive advantage from three main premiums:  

• Risk premium. Long-term investors that can absorb left-tailed risks over the shorter term should receive a premium, since other market participants are willing to pay to avoid these risks. Understanding risk tolerance and management is therefore important. In practice, most investors have a number of risk buffers that can be used to absorb differing levels of downside outcomes.   
• Complexity premium. Smart beta ideas require more governance than plain-vanilla assets such as equities and bonds. This requires expertise in understanding strategies, risk and position sizing, and monitoring. However, diversity with smart beta might be a good governance budget approach for investors with moderate capabilities.  
• Liquidity premium. Investors with less need for liquidity are better able to focus on the long-term journey and take advantage of a premium demanded by those who cannot. 

“There are also a number of rational reasons why diversifying strategies such as reinsurance, commodities, emerging market assets, volatility premium and momentum strategies should offer a premium when accessed via smart beta. Smart beta is simply about trying to identify good investment ideas like these that can be structured better, whether by improving existing beta opportunities, or creating exposures or themes that can be implemented in a low-cost, systematic way. Certain types of investors can, and are, taking advantage of these opportunities, and we expect this to accelerate, but investors need to maintain vigilance around price and proposition,” said Matt Stroud, head of strategy and portfolio construction at Towers Watson.  

Global Investment Matters, which will also be available from the App Store, covers topical investment issues and includes articles about:  

• Managing pension risks better and adding value. How risk management can positively affect your pension fund; 
• Questions of governance. Three pension funds discuss their different governance models; 
• Management of risk by multinational companies. What companies are doing about the financial risks of their defined benefit pension plans; and 
• Will fund managers learn to love social media? As investment managers are constantly striving to differentiate themselves, can social media help?