(March 29, 2013) – Let’s get real: the vast majority of investors’ return-seeking assets are equities, and diversifying away from that risk exposure is an expensive prospect right now.
Some of the largest, most sophisticated investors have sought to solve this problem with direct investments in real assets or infrastructure; others have turned to risk parity products. But some of the most successful risk-balance funds are unavailable, including Bridgewater’s closed All-Weather, and buying forests or toll roads may not be feasible for the average institution.
Another option for long-term diversification is smart beta. According to Towers Watson’s latest publication, smart beta is currently particularly smart.
“Being in the risk business for the long haul may be an unfortunate fact of life,” the authors wrote. “The arguments for risk mitigation with diversity are more subtle or nuanced than have been portrayed in the past but are, in our opinion, still valid. This is perhaps more so over the longer than the shorter term. The use of smart beta is a way for investors to access ‘good’ diversity at modest cost and governance.”
Smart beta can offer an edge for long-term investors over equities due to three primary premiums, according the publication:
1.) Risk premium. Other market participants are willing to pay to avoid left-tailed risks over the shorter term, leaving a premium for long-term investors who can absorb them.
2.) Complexity premium. Smart beta ideas require more governance than plain-vanilla assets such as equities and bonds, Towers Watson noted. 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.
3.) Liquidity premium. Investors with less need for liquidity can take advantage of a premium demanded by those who need it.
“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,” said Matt Stroud, head of strategy and portfolio construction at Towers Watson. “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.”
Another paper on smart beta by the Edhec-Risk Institute recently underscored the need for vigilance and thoroughness on the part of investors looking to allocate to the strategy. Sales and marketing are powerful forces in this space, it argued, and the more transparency provided about what makes a beta option smart, the better.
Related article: “Smart Beta 2.0 – Or How to See Through Biased Marketing”