Are we a long way off from those benchmarks being applied to other areas, e.g., smart beta within fixed income or within ESG?
Brown: As for entering other asset classes, we’ve learned a lot over the last 40 years in terms of benchmarking, but I think the vast majority of smart-beta assets are in equities, so that’s probably where that new process will start.
Like it has been for asset management over 40 years, it’s going to be a bit of an evolution, but I think in this case, depending how we define the rules, it may not be so difficult to create benchmarks. We already have benchmarks for [nonsmart-beta ETFs], so it’s not like we have to create them out of thin air.
And once we start to accurately judge smart-beta performance, will that have some kind of shakedown effect on the wealth of smart-beta products on the market?
Brown: Personally, I think the shakedown is going to come whether or not those benchmarks are created. There are only so many assets to go around. I’m not sure I understand the economics of creating one more ETF of which there are already 40, or creating something that doesn’t exist, as there’s got to be some reason that it doesn’t exist already.
In saying that, there are so many ways to define ESG [environmental, social, governance], for example, and investors have different views as to where they want to focus their investing.
But I do think that, by creating this benchmark, it could provide a shakedown of some sort—if an ETF is calling itself something different in the future, it will really have to outperform the other funds to survive.
Will the benchmarks have to change as investor trends and fads change?
Brown: I think the nature of creating rules for benchmarks is they need to evolve, in the same way that the S&P 500, the Russell 1000 or the MSCI World Index all evolve over time. Therefore I don’t think these [new, smart-beta] benchmarks will become obsolete.
Is there a lot of education still needed regarding smart beta?
Brown: There always is. Certainly this issue is no exception. You hear stories about brokers recommending strategies and they have no idea what’s in them. So when things go pear-shaped, they can’t respond in the right way. If you have a benchmark, you can analyze what’s gone right or wrong, whether a certain category of stocks has performed, for example, or if the ETF has outperformed its peers.
I think there’s a lot of education needed for the financial advisor and investor community. I’ve been working in this business for a really long time, and it’s gotten a little bit better, but not dramatically so.
Too often people just buy recent performance. That’s not new, but it’s important to understand that recent performance and determine whether that will continue or reverse.
But isn’t past performance more accurate with passive funds, as they are rules-based and don’t depend on human decisions like active funds do?
Brown: Yes that’s probably true. But I’m not completely convinced that just because something is rules-based means it isn’t active.
Let me explain: What can I do with my money? I can put my money in an index fund or I can invest in a strategy that’s expected to beat that index fund, and the latter is active, regardless of whether it’s rules-based or whether it’s an active manager going out and visiting companies and selecting stocks.
The expectation is that strategy will beat the market. Otherwise, why would you pay the higher fee?