“Smart” or “strategic” beta. The name sounds enticing; as an investor of course we all want to be smart and strategic. In the ETF world, we’ve seen a number of “smart beta”/”strategic beta” funds recently launched. These funds are positioned as a twist on the traditional indexing approach, a hybrid between passive and active management. While they generally continue to follow an index, these funds have specific construction criteria that weed out securities that don’t fit their set “rules” or “factors.” It could be something as simple as constructing an ETF with an equal-weight approach versus a market capitalization weight approach for an equity index, or screen for companies with dividend growth or low volatility. Or some smart/strategic beta ETFs focus on more detailed screening that include a number of “factors” (thus making them “multi-factor” smart beta ETFs).
The premise behind passive/index-based products is that they offer broad exposure to a market at a lower cost, while the argument for active management is that the human element and focusing on individual security selection can allow for the ability to outperform an index. These smart/strategic beta vehicles claim to be a means to enhance portfolio returns and reduce risk versus the index as they try to exploit market inefficiencies with their “factors” and offer a lower cost alternative to active investing. Others say that this is just a means for those managers/issuers to charge a higher fee then they would for a pure index-based product. The concept is relatively new, so only time will tell. Additionally, we have seen some people question as to whether this sort of vehicle would result in much higher transaction costs given the monthly (or more frequent) rebalancing to fit the criteria.
While this vehicle type may work in some segments of investing, such as screening out for lower volatility securities within a broader equity index or changing the weight of a security from capitalization weighted to equal weighted, we aren’t convinced that this model really adds much to the high yield market. For instance, there was a recently issued smart beta ETF that screens for liquidity and credit quality. We haven’t seen the specifics as to what criteria they use, but generally speaking, we feel putting on arbitrary limitations within the high yield market isn’t wise. What if you are screening for securities based on “credit quality” using credit ratings? But in that case, who’s to say the credit ratings are accurate? We believe the ratings agencies should not be relied upon to determine the true credit quality of a company—they are reactive not proactive, often exclude key factors (for instance, we’ve seen them exclude a company’s cash balance when assessing leverage and liquidity), and not to mention we have all certainly seen the ratings agencies get it wrong (the sub-prime crisis evidence alone). Rather investors should look at the company’s fundamentals, understanding the outlook and other factors impacting the company as they determine the credit’s quality and prospects. While not billed as a smart-beta ETF, some of the passive ETFs within the high yield market do have certain criteria that they use that narrows down the index, namely the size constraints. For instance, the two largest passive high yield ETFs have size constraints that limit their investments to primarily bonds that are over a $500mm tranche size in one case and over $400mm tranche size/$1bil in total debt issued by the company in another case. Our experience has been that size doesn’t necessarily equate to liquidity (if that is the concern and the reason for the size focus) and we have always felt these sort of limitations put investors at a disadvantage as it eliminates a sizable portion of the high yield market and what we see as many attractive investment opportunities within that eliminated portion.
High yield debt investing is a dynamic process. We believe that true active management and fundamental analysis is necessary in this market, with someone looking at an issuing company, analyzing it as a whole (not just a few “factors”) and making an investment decision; computer models alone can’t paint the full picture nor can some rules-based criteria. We believe that alpha comes from the individual credit decisions and the portfolio construction as a whole, and with that we believe the “smart” or “strategic” investing within the high yield bond and loan market is true active management.