The Biggest Failure in Investment Management: How Smart Beta Can Make It Better or Worse

Key Points

  • The negative gap between investor returns and fund returns is the biggest failure in investment management. Alpha is only a sideshow.
  • If we extrapolate the investor returns gap to smart beta strategies, poor client timing will completely negate the potential for positive excess returns.
  • The client service model for smart beta strategies needs to be radically different from other types of strategies to produce better investor outcomes.

What is the mission of investment management? Our interpretation is simple: to maximize the long-term value of the assets we are retained to manage. How do we measure our effectiveness? More than 50 years ago, the Bank Administration Institute (BAI), striving to help pension clients appropriately compare their results and the results of their investment managers, conducted a study that concluded: “The time-weighted rate of return measures the results of investment decisions made by a fund manager. It is not affected by decisions about the timing and amounts of cash flows—decisions which the fund manager typically does not make” (Bain, 1996, p. 5). Twenty years later, a predecessor organization to CFA Institute developed standards for the calculation and presentation of investment performance results, known today as the Global Investment Performance Standards (GIPS®), which measure the time-weighted return of a manager or strategy.

Set on this necessary and valuable foundation, the main act in the investment industry has traditionally been the pursuit of alpha. Research and investment management professionals engaged in active management have sought strategies to generate excess returns, and in the case of passive managers to design the most efficient strategy to capture a given market exposure. In both cases, minimizing transaction costs wherever possible helps clients’ results more closely match the “paper portfolio.” We know how well a manager is doing by measuring the time-weighted return of a strategy against a suitable benchmark. The practice of performance measurement and the databases it’s built on have become a sizeable industry on their own. But the overwhelming focus on time-weighted alpha, which receives center-stage attention, is only a sideshow. As we’ll explain, the client performance experience can deviate, sometimes wildly to the downside, based on investors’ timing of cash flows into and out of their selected investment strategies, which leads to a return gap.

The investing and divesting decisions that drive this gap, as the BAI report noted, are not typically made by the fund manager, but by the investor. What does this mean in smart beta, which has so many backtested returns? As purveyors of smart beta indices, we are interested in helping produce better outcomes for smart beta investors and wholeheartedly believe a robust client-service effort can assist in closing this return gap. We’re convinced a client-service conversation that builds investor confidence in the selected style and helps the investor understand the ups and downs of a long investing journey will result in substantial progress toward closing the gap. To successfully implement this smart-beta client service approach requires, however, an altogether different mindset than the market has adopted until now. But we are confident its time has come.