Alpha, Beta, and Beyond

NEW YORK – Even in normal times, individual and institutional investors alike have a hard time figuring out where to invest and in what. Should one invest more in advanced or emerging economies? And which ones? How does one decide when, and in what way, to rebalance one’s portfolio?

Obviously, these choices become harder still in abnormal times, when major global changes occur and central banks follow unconventional policies. But a new, low-cost approach promises to ease the challenge confronting investors in normal and abnormal times alike.

In the asset management industry, there have traditionally been two types of investment strategies: passive and active. The passive approach includes investment in indices that track specific benchmarks, say, the S&P 500 for the United States or an index of advanced economies or emerging-market equities. In effect, one buys the index of the market.

Passivity is a low-cost approach – tracking a benchmark requires no work. But it yields only the sum of the good, the bad, and the ugly, because it cannot tell you whether to buy advanced economies or emerging markets, and which countries within each group will do better. You invest in a basket of all countries or specific regions, and what you get is referred to as “beta” – the average market return.

By contrast, the active approach entrusts investment to a professional portfolio manager. The idea is that a professional manager who chooses assets and markets in which to invest can outperform the average return of buying the whole market. These funds are supposed to get you “alpha”: absolute superior returns, rather than the market “beta.”

The problems with this approach are many. Professionally managed investment funds are expensive, because managers trade a lot and are paid hefty fees. Moreover, most active managers – indeed, 95% of them – underperform their investment benchmarks, and their returns are volatile and risky. Moreover, superior investment managers change over time, so that past performance is no guarantee of future performance. And some of these managers – like hedge funds – are not available to average investors.

As a result, actively managed funds typically do worse than passive funds, with returns after fees even lower and riskier. Indeed, not only are active “alpha” strategies often worse than beta ones; some are actually disguised beta strategies (because they follow market trends) – just with more leverage and thus more risk and volatility.

But a third investment approach, known as “smart” (or “enhanced”) beta, has become more popular recently. Suppose that you could follow quantitative rules that allowed you to weed out the bad apples, say, the countries likely to perform badly and thus have low stock returns over time. If you weed out most of the bad and the ugly, you end up picking more of the good apples – and do better than average.

To keep costs low, smart beta strategies need to be passive. Thus, adherence to specific rules replaces an expensive manager in choosing the good apples and avoiding the bad and ugly ones. For example, my economic research firm has a quantitative model, updated every three months, that ranks 174 countries on more than 200 economic, financial, political, and other factors to derive a measure or score of these countries’ medium-term attractiveness to investors. This approach provides strong signals concerning which countries will perform poorly or experience crises and which will achieve superior economic and financial results.

Weeding out the bad and the ugly based on these scores, and thus picking more of the good apples, has been shown to provide higher returns with lower risk than actively managed alpha or passive beta funds. And, as the rankings change over time to reflect countries’ improving or worsening fundamentals, the equity markets that “smart beta” investors choose change accordingly.

With better returns than passive beta funds at a lower cost than actively managed funds, smart beta vehicles are increasingly available and becoming more popular. (Full disclosure: my firm, together with a large global financial institution, is launching a series of tradable equity indices for stock markets of advanced economies and emerging markets, using a smart beta approach).

Given that this strategy can be applied to stocks, bonds, currencies, and many other asset classes, smart beta could be the future of asset management. Whether one is investing in normal or abnormal times, applying a scientific, low-cost approach to get a basket with a higher-than-average share of good apples does seem like a sensible approach.