The World of Beta

by: Richard Kang

I read a most interesting submission last week from Matt Hougan, of, regarding the "Superbowl of Indexing" conference in Arizona. Here are some of my thoughts on Matt’s observations:

• “The Indexing Swagger”: This is an interesting paradox. The irony is that the ETF industry, and those who are proponents of the implementation of ETFs within an investment portfolio, have based their arguments on the fact that active management is filled with many flaws that, in aggregate, form a drag on investment returns. The main factor is costs [trading costs, management fees, tax implications, etc.]. But another factor is simply that it’s difficult for an active manager within a particular asset class to beat his or her relative benchmark, after costs. Furthermore, for the relatively small number of managers who do beat the index in a relatively consistent manner, it is very difficult for investors to select them in the appropriate time.

This leads to the fact that many investors have returns worse than the appropriate index, as well as a buy-hold strategy of the median fund [both for the appropriate asset class]… the exercise of getting in and out of mutual funds is actually detrimental to their portfolio’s performance. So, to me at least, the indexing industry is one built on a philosophy of humility. “It’s difficult to beat the index, so why not just match it” is a common phrase used by some index providers. This mentality does not come with a swagger. But I suppose times are changing. I can’t quite imagine a bunch of dark suits in Arizona doing a John Travolta strut at last week’s event. Furthermore, based on where the industry has come from, I am a bit disconcerted about the shift away from the traditional view of indexing as a means of truly passive investing.

• This last sentence I’ve written above is rather hypocritical of me to write. I come from the hedge fund industry, where I started in the industry tactically trading financial futures as well as ETFs [back when they were called WEBs]. At that time there was only a small number of instruments like SPY and QQQ that had significant liquidity. It would be naive of me to think that there are not many other market participants who have been trading ETFs [and other instruments for cheap and broad beta exposures] in a highly active manner. Thus, it is not at all surprising to me that tactical asset allocation [TAA] is a big buzzword in the ETF industry. With the number of geographical regions, industry sectors, and investment styles now available through ETFs, what would you expect but for investors and managers to build TAA programs.

In reality, anyone can be a hedge fund manager and applying a global macro mandate is the logical next step beyond TAA. My disconcerted feelings stem from the fact that, even with my background in trading beta, I honestly believe that a core portfolio of well diversified market exposures managed more in a “strategic asset allocation” context, rather than a “tactical asset allocation” context, is most prudent. This certainly would make sense for one’s tax deferred investment account. I suppose there’s a balance to have a conservative core portfolio built with a low cost, broadly diversified “Boglesque”-type mandate and superimpose on this a more ambitious TAA-type mandate. This leads to a portable alpha approach to portfolio management, which is gaining significant acceptance in the institutional world. Only with ETFs is portable alpha a realistic possibility for retail investors and next year's EDHEC Asset Management conference in Geneva is a good example of this.

• I read with great interest Matt Hougan’s comments in the section titled “The Flipside [And Scarcity] Of Alpha”. In the past, I’ve written about my concerns for finding alpha. I’m not sure if it will get harder as hedge funds are in the business of finding new markets and new strategies to exploit market inefficiencies. What concerns me is the large number of market participants that quickly enter such areas and dilute the opportunity set. The concept of ETFs attempting to “beat the market” is, to me, simply an explanation of how the industry is moving away from market cap weighted indexing. I don’t think Malkiel, Bogle and other like-minded individuals will be able to alter the shift that is occurring. Whether it’s good for investors is yet to be seen. I suppose my only concern is if investors get caught in the same trap as in the mutual fund world … trading too much too often leading to suboptimal portfolios with poor performance. Essentially, chasing returns.

• The rest of the piece covers some fairly obvious observations in the ETF industry, such as the recent focus on commodities as well as the push to greater international exposure.

What I would like to leave off with is a short list of other upcoming industry conferences that relate to the world of beta [not just specifically ETFs]. The previously cited event by EDHEC is geared towards professionals in the wealth management space, but most beta management conferences are organized for institutions. Here are some interesting ones:

World Series of ETFs: March 26-27, 2007, Miami, Florida. This is from the same organizers as the “Superbowl of Indexing” conference. Not as big of an event but likely lots of overlap if you missed out last week. Probably the best mix of retail and individual representatives you could find for an ETF event.

Beta Risk and Management:
January 24, 2007, The Harvard Club, NYC.This conference is for the institutional crowd although there’s no reason why the concepts discussed here can not be applied to the individual investor’s portfolio.

A New Understanding of Hedge Fund Returns: February 12 - 14, 2007, The Landmark, London, United Kingdom. This is where things get complicated as the world of beta and hedge funds collide. A major area of discussion will definitely be replication strategies including the works of Harry Kat. We can only wonder if Goldman Sachs will be there to discuss their recipe as well.

World Cup of Investment Management: February 5-6, 2007, Rome, Italy. A last thought on the increasing dominance of ETFs. Here’s the agenda for a conference [again from the same organizers as the “Superbowl of Indexing” conference] but this one has a title that is much broader. Note the topics listed for day one. Nearly all discuss ETFs. Some related topics [enhanced indexing, commodity indexing] get pushed into day two. Many of the other topics revolve around broader portfolio discussions [asset allocation, portable alpha, risk management], but you can see how significant the area of beta is for an event that is not marketed as a World Cup of Indexing but a World Cup of Investment Management.

Still can’t get that Travolta strut out of my head.

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