Most smart-beta offerings fall into the same trap as index strategies: blindly following a set of criteria even when the strategy is underperforming. Instead, beta harvesters should be more thoughtful, according to Tim Gardener, head of institutional client strategy at AXA Investment Managers, who also believes smart-beta strategies are overpriced.

“In beta strategies, market cap or otherwise, you don’t want to blindly follow them south,” he says. “The problem with alternative indices is that if it goes south, there is no mechanism for stopping it.”

Instead, he says, beta management should be more thoughtful.

“At any point in time – whatever the index you choose – there will be a proportion of stocks where the percentage chance of them performing badly is greater than them performing well. A beta harvester says invest unless there’s an obvious reason not to. There is nothing smart about tracking an index: you buy rubbish stocks without thinking about it. Passive management is an opportunity lost for a very small reduction in risk.”

Part of the problem with this new breed of beta management is language, he says, because there is no middle way.

“If you’re not passive, you’re active,” he says.

But Gardener believes there are three states of investment management.

At one end is the unconstrained manager then, at the other end, the manager who defines a set of rules and blindly follows them wherever they go. In the middle, there’s the active-index manager.

This latter category thinks in an active way about the premia, he says.

“The objective is not to choose an index and track it, but to have cheap beta and minimise the downside,” he says. “The focus is on absolute real return, not on tracking an index. I worry that with alternative indexes, investors are jumping out of the frying pan into the fire.”

Gardener says a beta strategy reflects as closely as possible the value of the company in the present and as soon as it becomes about a perceived future, it is an active strategy.

However, Gardener is cognisant that it will require quite a shift to move away from market-cap indexes, with the entire industry, product offering and performance attribution, built on market cap. Not that it necessarily makes it OK.

“I’ve been talking about market cap being lousy for 25 years,” he says. “Price doesn’t reflect value because it is based on behaviour, and behaviour is not logical but herd-like.”

But he admits that market cap has a certain seduction, and satisfies the natural tendency of wanting objectives to be measurable.

Gardener says that the right price for a smart-beta strategy is 10 to 20 basis points, and that it is a bit high at the moment.

Tim Gardener will speak at the AIST ASI Conference on the Gold Coast this week.

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