Economic Growth

Is smart beta the future of asset management?

Nouriel Roubini
Professor Emeritus of Economics and International Business, Stern School of Business, New York University
Share:
Our Impact
What's the World Economic Forum doing to accelerate action on Economic Growth?
The Big Picture
Explore and monitor how Economic Progress is affecting economies, industries and global issues
A hand holding a looking glass by a lake
Crowdsource Innovation
Get involved with our crowdsourced digital platform to deliver impact at scale
Stay up to date:

Economic Progress

Even in normal times, individual and institutional investors alike have a hard time figuring out where to invest and in what. Should one invest more in advanced or emerging economies? And which ones? How does one decide when, and in what way, to rebalance one’s portfolio?

Obviously, these choices become harder still in abnormal times, when major global changes occur and central banks follow unconventional policies. But a new, low-cost approach promises to ease the challenge confronting investors in normal and abnormal times alike.

In the asset management industry, there have traditionally been two types of investment strategies: passive and active. The passive approach includes investment in indices that track specific benchmarks, say, the S&P 500 for the United States or an index of advanced economies or emerging-market equities. In effect, one buys the index of the market.

Passivity is a low-cost approach – tracking a benchmark requires no work. But it yields only the sum of the good, the bad, and the ugly, because it cannot tell you whether to buy advanced economies or emerging markets, and which countries within each group will do better. You invest in a basket of all countries or specific regions, and what you get is referred to as “beta” – the average market return.

By contrast, the active approach entrusts investment to a professional portfolio manager. The idea is that a professional manager who chooses assets and markets in which to invest can outperform the average return of buying the whole market. These funds are supposed to get you “alpha”: absolute superior returns, rather than the market “beta.”

The problems with this approach are many. Professionally managed investment funds are expensive, because managers trade a lot and are paid hefty fees. Moreover, most active managers – indeed, 95% of them – underperform their investment benchmarks, and their returns are volatile and risky. Moreover, superior investment managers change over time, so that past performance is no guarantee of future performance. And some of these managers – like hedge funds – are not available to average investors.

As a result, actively managed funds typically do worse than passive funds, with returns after fees even lower and riskier. Indeed, not only are active “alpha” strategies often worse than beta ones; some are actually disguised beta strategies (because they follow market trends) – just with more leverage and thus more risk and volatility.

But a third investment approach, known as “smart” (or “enhanced”) beta, has become more popular recently. Suppose that you could follow quantitative rules that allowed you to weed out the bad apples, say, the countries likely to perform badly and thus have low stock returns over time. If you weed out most of the bad and the ugly, you end up picking more of the good apples – and do better than average.

To keep costs low, smart beta strategies need to be passive. Thus, adherence to specific rules replaces an expensive manager in choosing the good apples and avoiding the bad and ugly ones. For example, my economic research firm has a quantitative model, updated every three months, that ranks 174 countries on more than 200 economic, financial, political, and other factors to derive a measure or score of these countries’ medium-term attractiveness to investors. This approach provides strong signals concerning which countries will perform poorly or experience crises and which will achieve superior economic and financial results.

Weeding out the bad and the ugly based on these scores, and thus picking more of the good apples, has been shown to provide higher returns with lower risk than actively managed alpha or passive beta funds. And, as the rankings change over time to reflect countries’ improving or worsening fundamentals, the equity markets that “smart beta” investors choose change accordingly.

With better returns than passive beta funds at a lower cost than actively managed funds, smart beta vehicles are increasingly available and becoming more popular. (Full disclosure: my firm, together with a large global financial institution, is launching a series of tradable equity indices for stock markets of advanced economies and emerging markets, using a smart beta approach).

Given that this strategy can be applied to stocks, bonds, currencies, and many other asset classes, smart beta could be the future of asset management. Whether one is investing in normal or abnormal times, applying a scientific, low-cost approach to get a basket with a higher-than-average share of good apples does seem like a sensible approach.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House’s Council of Economic Advisers during the Clinton Administration.

Image: A worker arrives at his office in the Canary Wharf business district in London February 26, 2014. REUTERS/Eddie Keogh.

Don't miss any update on this topic

Create a free account and access your personalized content collection with our latest publications and analyses.

Sign up for free

License and Republishing

World Economic Forum articles may be republished in accordance with the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International Public License, and in accordance with our Terms of Use.

The views expressed in this article are those of the author alone and not the World Economic Forum.

Share:
World Economic Forum logo
Global Agenda

The Agenda Weekly

A weekly update of the most important issues driving the global agenda

Subscribe today

You can unsubscribe at any time using the link in our emails. For more details, review our privacy policy.

What can employers do to combat STEM talent shortages?

Timo Lehne

May 21, 2024

About Us

Events

Media

Partners & Members

  • Join Us

Language Editions

Privacy Policy & Terms of Service

© 2024 World Economic Forum