The age of disruption

Disruptive innovation and smart beta

In January 2016, the CFA Institute's Financial Analysts Journal published an article titled ‘The Asset Manager's Dilemma: How Smart Beta is Disrupting the Investment Management Industry.'

In their paper authors, Ronald Kahn and Michael Lemmon compared, what they called, ‘pure alpha’ being generated by global active managers to the fees they were charging. ‘Alpha’ is financial industry jargon for outperformance above the market benchmark. The ‘pure alpha’ the authors refer to is the alpha that cannot be explained by smart beta factors. Therefore alpha can be attributed to ‘factors’ and ‘pure alpha’.

Kahn and Lemmon examined 79 global managers whose funds were benchmarked to either the MSCI World Index or the MSCI ACWI Index. What they found is presented below. The bar chart shows the proportion of the outperformance above the benchmark that can be explained by the smart beta factors. The closer to zero, the more ‘pure alpha’ that is generated.

_{The Asset Manager’s Dilemma: How Smart Beta is Disrupting the Investment Management Industry. Financial Analysts Journal}

We can draw the following conclusions from the above bar chart:

• There is a large variance between managers in performance;
• For the average manager, 33% of active return that is over and above the MSCI World Index can be explained by smart beta factors; and
• For 30% of the managers, more than 40% of the return can be explained by smart beta factors.

The scatter diagram above on the right, combines the data in the bar graph with the actual fees being charged (the dark blue dots) and predicted fees (the light blue dots). The predicted fees represent what the authors of the paper think investors should be charged based on the amount of ‘pure alpha’ being produced.

The light blue dots are downward sloping, showing lower fees should be paid for smaller amounts of alpha. The grey highlighted area, according to the authors, shows roughly those funds that are most likely to be disrupted by smart beta. There are 29 out of 79 in the sample. That is over 35% of global equity managers, according to Kahn and Lemmon that will be disrupted by smart beta.

This highlights the need for active managers to evolve in response to this disruptive innovation. Most active managers deliver some combination of smart beta and pure alpha, and Kahn and Lemmon suggest these managers “should analyse their relative strengths and move toward offering either smart beta or pure alpha with appropriate fees.”

The above suggests that current fee levels are inconsistent with the outcome. They are too high.

The disruption is happening in Australia

The funds management industry in Australia has largely been protected from disruption. We believe a tectonic shift has commenced. In Australian active managers are responding and it’s straight out of the playbook outlined in the CFA Institute's Financial Analysts Journal. We are witnessing active managers explore ways to offer systematic approaches at a more palatable fee.

This is not without risks as it means clients paying the existing, inconsistent fees may move to this new approach which will result in cannibalisation. This however is more palatable than losing clients to a competing smart beta strategy. What happens too when the pure alpha approach underperforms the low-cost approach?

Our observation of the US experience demonstrates mixed success for active fund managers offering both systematic and pure active exposures. It is common for the systematic offering to fail to attract attention, more importantly it can emphasise deterioration in the pure alpha strategy.

Those fund managers who can demonstrate persistent ‘pure alpha’ however will thrive. But we think mixed offerings will become more common among active fund managers in Australia.

Active fund managers have often used management jargon like ‘disruptive innovation’ in their marketing when they describe how they assess the companies and industries they invest in. Often they do not apply this framework to their own business. Now to compete with existing smart beta strategies they have to recognise they are being disrupted. At the very least they need to lower fees and increase transparency to ensure their long-term survival.

We expect more active fund managers to assess their mix of pure alpha and smart beta and then adjust their product offerings accordingly.

Those that don’t, will not survive.