Alan Price, sales director at Indxis, the index services provider, explains how enhanced beta strategies can function as a neat compromise between active and passive investment strategies.

Alan Price, sales director at Indxis, the index services provider, explains how enhanced beta strategies can function as a neat compromise between active and passive investment strategies.

It is the bad dream of every wealth manager or private banker: to explain to a client not only why an actively-managed fund has underperformed, but also why the client has paid upwards of 1.5 per cent in fees for the privilege of losing their capital.

Scenarios such as this, paired with the increasingly widespread belief that very few active managers can actually deliver alpha on a sustained basis, continue to fuel the active/passive debate. Although every investor would like to see returns over and above the market, many are no longer willing to risk paying high management fees when there is no guarantee of outperformance.

On the other hand, passive investing presents plenty of upside: diversification, transparency, strict risk parameters, liquidity and, importantly, lower fees. As a result, many investors are willing to settle for meeting - rather than beating - market returns.

Finding a halfway house

But there is a half-way house which is gaining traction in parts of the asset management industry: strategies that seek to generate “alternative”, “smart”, “intelligent”, “advanced” or “enhanced” beta. Whatever the nomenclature, this type of return is generated by rules-based funds that are more strategy-driven than pure beta products but not quite actively managed.

An enhanced beta strategy aims to generate alpha-like returns for investors by providing exposure to a market or market segment through an index weighted in a particular way. Instead of a traditional market-cap weighting, for instance, an index might be tilted towards small cap or value stocks to take advantage of the return premia associated with these characteristics. As such, the pursuit of enhanced beta marks the next step on from simple trackers while retaining the upsides of transparency, liquidity and low fees that are characteristic of classic passive investing.

One such strategy is Mergent’s UK Dividend Achievers Index, which is composed of stocks that have increased their annual dividends for the last five or more consecutive years and, as such, is weighted towards income-generating equities. Over the past three years, the Index has delivered annualised returns of 13.18 per cent in comparison to 7.54 per cent by its MSCI UK benchmark.

Following its initial formulation, this Index is reconstituted only once a year - although issues are removed from the Index at any time for corporate actions - meaning that there is little active management and costs are consequently kept to a minimum.

Another strategy which aims to capture enhanced beta is the GAIA Global Farming Index which invests in listed companies that mainly operate farms producing meat, grains, edible oils, dairy, fish and other diversified farming methods. Risk is reduced through a modified market capitalisation weighting methodology; no single company may exceed 3 per cent of the Index as of each quarterly reconstitution date, and will be modified if this becomes the case.

Once again, the Index has delivered good returns, generating 10.3 per cent over one year on a cumulative basis since launch. Over the past four years, it has returned 18.4 per cent based on back-tested data, strongly outperforming such references as the MSCI Emerging Markets SMID (12.9 per cent), the Market Vectors Agribusiness ETF (MOO) (9.6 per cent) and the Claymore Global Agriculture ETF (COW) (7.7 per cent) over the same period.

Managing risk

Enhanced beta strategies can also be employed to manage risk within a larger portfolio; for example, an index which is weighted towards low volatility stocks - yet still attractively valued - can provide superior risk-adjusted performance. Although the performance of this type of index may not match that of the underlying assets in a market rally, the cushioning it provides in a downturn means it can be a useful addition to a portfolio.

As indicated by the above examples, enhanced beta strategies are extremely flexible in terms of which asset classes they offer exposure to, their investment styles and their position on the risk/return frontier. When it comes to client portfolios, the size of holdings should depend on the underlying asset; indices with a high emerging markets exposure would, for instance, typically have a relatively small allocation, although clearly this depends on the individual investor’s risk profile.

Although they are unlikely to (and should not) replace alpha strategies entirely, enhanced beta strategies certainly have a place in client portfolios.