Contrarian Investor: Time to pay for what investors get with smart beta?

Passive fees under pressure

clock • 4 min read

A new approach to index pricing could disrupt the traditional model, and enable investors to relate their fees directly to smart beta index performance, writes David Stevenson.

Most readers have already probably had their fill of all things smart beta related, given last week's multi-channel discussion, but an announcement from the academics behind index outfit ERI Scientific Beta has sparked an important debate on index fees, and why they are far too high, especially in the world of smart beta.

Is smart beta a marketing fad or the real deal?

To understand the broader context, let us take it as given that nearly every fund manager - and wealth adviser for that matter - is now increasingly fixated on reducing the product cost.

Just last week M&G, for instance, announced a fairly meaningful cut in fees charged through its new online service. As these fees start coming down, providers will look at every part of the value chain in order to shave costs.

Vanguard Europe MD: There is room for passive and active fees to go lower

Index fees, be they simply benchmarking licences for active managers or index provision for ETF issuers, are an increasingly large part of the equation.

Given most plain vanilla ETF products will probably boast factory gate pricing of not much more than 20bps within the next few years, the typical index provider's fees of anything between two and 20bps makes a huge difference, although the big index providers with the well-known brand names like the FTSE 100 will no doubt argue their product is hugely valuable, and worth every penny.

The push to reduce index costs will also be partly motivated by the realisation among many asset managers that the big outfits are now valuable business outfits with cracking cashflow profiles and lucrative profit margins.

Smart beta pressure

My suspicion is that smart beta funds will feel the pressure first. In part, this is because of their very reason for existing - providing better risk-adjusted returns that are comparable to actively-managed funds but with less manager idiosyncrasy.

Investors are buying these funds to replace actively-managed funds and this means the end user needs to see outperformance.

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The flip side of this is index providers understand this requirement, which by and large ends up turning into a higher charge for index provision. More complicated strategies require more thought and research which, in turn, costs more for the end user.

As a side note, this push for more active overlays does not always translate into greater transparency. I have just embarked on a small project to pull the underlying methodology for every UK-listed smart beta ETF.

The level of explanation both by issuers and index providers is generally lamentable. Clearly, the extra fees for smarter strategies are not finding their way into website communication.

It is becoming increasingly obvious that returns are also more than a bit patchy. On both performance and transparency measures, the smart beta movement is not shaping up well at this stage.

Time for more radical measures such as reducing fees or, more controversially, allowing index fees to be performance-based.

Vanguard launches first actively-managed funds for UK market

Perish the thought that a 'superior investment strategy' is only rewarded if it is actually superior to the plain vanilla benchmark.

Rewarding performance

The good news is this is exactly what is being promised by the academic pointy heads at Scientific Beta, the smart beta index provider offshoot of EDHEC Risk Institute.

This relatively new index provider has  just announced what it calls "a revolutionary pay for what you get" approach to index pricing that will disrupt the traditional model of fixed fees on assets under management and enable investors to relate their fees directly to smart beta index performance.  

According to Noël Amenc, CEO of ERI Scientific Beta, the rationale for this mandate offer is that "smart beta providers' claims on the quality and robustness of their strategies should materialise in their live performance".

It is also worth observing EDHEC scores very highly in the transparency department with all their indices explained in fastidious detail. Hopefully, this idea of performance by results begins to catch on in the index space among EDHEC's competitors.

Who knows what might be next - platforms only charging users if they deliver extra value? While we are at it, let us add administrators and trustees to the long list of service providers who are only paid for results.

David Stevenson is an FT columnist, editor at Portfolio Review and consultant

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