By Mustafa Sagun, Chief Investment Officer, Principal Global Equities
Before Netflix (NASDAQ:NFLX), Pandora (NYSE:P), and Amazon (NASDAQ:AMZN), there was Blockbuster Video that rented video tapes and compact discs (CDs). The younger side of the millennial generation may not know what I'm talking about, because the new technology of streaming videos and listening to podcasts has taken over video tape and CD rentals. In the 1990s, we all rented videos for entertainment, but when a video tape was returned late, even if it were by one day, we had to pay a hefty late fee. We were even charged a "rewind" fee if the video tape wasn't rewound to the beginning! Those fees really hurt on a low budget. I hated paying late fees, and I wasn't alone! Although Blockbuster's business flourished as the majority of its revenues came from these dreaded late fees, not many people asked "How can you make a sustainable business from fees that your clients don't want to pay?" Blockbuster enjoyed growth in revenues; that is, until the new disruptive technology came and changed the industry. Take Netflix, for example. Customers NEVER had to pay late fees, and Blockbuster went bankrupt later on!
Netflix disrupted Blockbuster's business model, much like risk premia-based investing (also known as smart beta) is disrupting the asset management industry. Smart beta is the measure of certain factors, such as value, momentum, quality, and size: styles that every manager is associated with or advisors would pick managers from. Even if most of us fundamentally-oriented active managers think developments in smart beta approaches won't impact us, I believe they will. To be more specific, I believe they will impact our fees, similar to the Netflix/Blockbuster situation. This disruption has made it crucial for us to take a deeper look into our organizations to identify fees that our clients don't want to pay - our "late fees."
"Alpha"-level fees charged for mostly "beta" returns are our version of "late fees." Beta is cheap, and alpha is expensive. Smart beta is about separating alpha from beta. Beta is defined as an asset's move explained by market movements, such as an index. Alpha is an asset's return in excess of its "beta" adjusted expected return. Alpha also captures forecasting skill, not explained by simple style betas. If you have been charging alpha (high active) fees for mostly (style) beta, watch out! Those fees will be coming down, as smart beta providers have been introducing more stylistic beta-based products at a lower cost.
You are not immune even if you have picked stocks bottom-up your entire career, or if you are a prominent hedge fund and have never used a quant factor in your life. If the client runs attribution and finds out that, say, 80 percent of your performance is explained by these style betas, the client has a decision to make; especially if you are charging them 2 and 20! The beta portion, the 80 percent of your portfolio in this example, could be worth just 20 basis points, which can be replicated easily with the new smart beta ETFs.
We should all look at our businesses very carefully with a client-centric eye. Identify the fees that can be wiped out with this disruptive force and adjust fees fairly, reflecting the value of alpha and beta components when possible. Making clients happy is the recipe for long-term success. Organizations unable to do so will likely suffer the fate of Blockbuster Video. "Smart Beta and chill" likely won't replace the phrase "Netflix and chill," but who knows, especially after some intense quant modeling parties!