The rise and rise of so-called ‘smart beta’ investment strategies will hopefully spur the development of asset allocation techniques that better suit the needs of modern day private clients.
This is the view of Sarasin & Partners’ head of quantitative investing Andrea Nardon, who expects to see the continued development of the middle ground between pure beta plays, such as trackers, and the alpha-generating strategies that have historically been associated with active managers.
‘Today, with smart beta, we are looking at different styles or factoring and the benefit for private clients, as for any other investor, is that we have substantially different building blocks for asset allocation than we have ever had.
‘If you look specifically at smart beta, it has the advantage for a private client that the cost is lower than running an active discretionary product. That should naturally be reflected in the fees. For a private client it is possible today to access smart beta products, like low volatility products, at a very competitive fee that was simply not possible 10 years ago,’ he says.
‘I think this evolution is bringing a lot more options to the table so there are far more available building blocks, which is great because more options mean more opportunities.’
Another by-product of this evolution is margin compression in active management, Nardon notes, representing a trend he anticipates will continue for some time.
‘What people have not realised is that the evolution is stressing the need for better allocation techniques,’ he adds.
Nardon hopes this will spur the development of asset allocation models that better match realistic expected returns for investors by minimising risk. This is quite the challenge, however, as the quant head takes the view that current models rely on unrealistic assumptions.
‘More theoretical work is needed to support asset allocation in the real world,’ he says. ‘Whenever we invest money we need to deal with the drawdowns, liquidity problems and situations that are very difficult to capture in a very simple mathematical problem. A lot of work will be done. I think risk is one of the most misunderstood concepts today.’
This is because risk should be viewed as the potential to lose money, Nardon points out.
‘In financial terms it [risk] is measured with variability and standard deviation, which is clearly designed to capture how securities fluctuate up and down. Clearly the risk for investors is only on the negative side. If the other side fluctuates into positive territory it isn’t really a risk,’ he says.
As head of quantitative investing, Nardon enjoys a dual role at Sarasin.
The softly spoken Italian oversees the firm’s quantitative strategy in emerging market equities, which has attracted some $1.3 billion (£787 million) in assets across private and institutional clients.
At the same time, he is currently exploring potential ways to develop smart beta strategies within the business outside of emerging market equities. He highlights absolute return as an area of interest due to client demand for returns with a lower risk profile than equities, particularly as the heady days of making 6-7% per year in bonds has come to an end.
Nardon suggests smart beta absolute return strategies could be used as an alternative to hedge funds by offering greater transparency and liquidity.
‘Another advantage of smart beta is that you can index an investment strategy, which means you can monitor how the investment strategy is doing because we have removed the discretionary overlay from selection, allocation and implementation. Provided the area you have invested is very liquid, you can have an index strategy designed to achieve a specific type of return.
‘Absolute return is where we need to have new products that are designed in a transparent way and are easy to understand because it is possible to achieve positive returns in the long run. This could be done in a quant or systematic way.’
The quant team and approach sits alongside Sarasin’s well-known thematic investment process. While thematic is the dominant modus operandi within the business, quant sits alongside thematic quite happily and has formed part of the firm’s investment proposition since the 1990s.
The growth of smart beta as a phrase among investors will prove supportive for quant investment approaches in the future, Nardon says, even though quantitative investing has been around for decades.
‘Our proposition in emerging markets today sits in the smart beta framework. It was launched as quant, it emerged into systematic, then rules-based and now we call it smart beta. The reality is our investment proposition has never changed effectively. We have just tried to refine the way we implemented the strategy,’ he says.
Nardon expects to see further development of smart beta strategies that find alternative ways to weight securities, for example by style, moving away from the traditional market cap method. He notes that when it comes to the development of these, asset managers and index providers both have a role to play.
Index providers can draw on the wealth of information at their fingertips and their ability to process that data, while asset managers have the edge when it comes to managing and trading stocks.
Nardon believes quantitative investing has a role to play in the expansion of smart beta.
‘It is possible we will get to a point where the line between systematic or quant will become effectively the same thing.
‘Smart beta is bringing attention and simple marketing materials around concepts that have been around for many decades, historically in quantitative territory. Now they are trying to simplify that and possibly a few years down the line they will realise that smart beta will become quant.’
What about the critics of smart beta?
Nardon recognises the nascent sector is not ‘the Holy Grail’ in terms of achieving returns that shoot the lights out but is keen to stress these strategies offer other benefits.
‘Smart beta is not the Holy Grail. I disagree it is not adding value. I think it is as you have more building blocks for an asset allocation process and you are delivering something specific and transparent.’
He also takes on board the views of those who are sceptical on quant following the credit crisis, which saw a number of quant strategies fail. He says the biggest mistake quant managers made was to fundamentally change their approaches after 2008.
‘At Sarasin, we believe continuity in how we are managing emerging market equities is a key element. The process was launched in 1996. We have gone through the Asian crisis, tech bubble and 2008.
‘The process has never really changed. What has changed is the way we are implementing the process.’
Nardon’s retail £51 million Sarasin IE Emerging Markets systematic fund holds a universe of 850 stocks through indices that he says are liquid and transparent. The strategy gives an equally weighted exposure across emerging market countries because the firm’s research shows the potential for country outperformance in emerging markets is not positively correlated to equity market capitalisation.
‘We know at any point of the day what the exposures in our fund are, the risks and assets,’ Nardon says. The fund has an ongoing charge figure of 0.9% and is rebalanced on a monthly basis.
Over the past five years to the end of July, Sarasin & Partners' Emerging Markets Systematic Strategy has posted a 48% return gross of management fees but net of transaction costs, versus the MSCI EM index's 42.5% rise.
Looking ahead, he says investors need to break down their preconceptions of active and passive, arguing that such a binary classification of investment strategies is outdated.
‘Where a lot of people get it wrong is in their association of the word active with discretionary fund managers. I think the classification between active and passive will evolve into discretionary versus non-discretionary approaches.
‘Within discretionary approaches you will have quantitative products where there is a very “complicated” model behind that is governing the investment decision. You have systematic products or alternative weightings to market cap. Then in that area you will also have market cap. This is where we are heading to.’