The rise of smart beta could force traditional UK active equity managers into extinction, according to Nick Samuels, Head of Equity Manager Research at investment consultants Redington.

Nick Samuels, Head of Equity Manager Research, Redington.

This warning comes amid intense debate throughout the last decade over the fees and effectiveness of active equity managers, and the growing sophistication of passive investment offerings such as exchange-traded funds (ETFs).

In the UK, active management has traditionally been the favoured investment approach, and AUM data suggest that it continues to thrive across asset classes. According to Investment Association data, 76% of assets under management are in active funds, 20% lie in traditional benchmarks via passive vehicles, while only 3% are in enhanced index or smart beta funds.

This, Redington’s Samuels asserts, is despite a rising body of seemingly damning research indicating that active managers have been unable to add value to investors’ portfolios over the last 10 years.

Samuel’s cite data from index provider S&P showing that actively managed UK equity funds have routinely failed to beat their benchmark, with three-quarters of managers in this category underperforming over the past decade.

This money being left with underperforming managers can largely be blamed on investor inertia, says Samuels. However, even those active equity managers that are beating their respective market-weighted benchmarks may still not be justifying fees.

According to Samuels, smart beta and enhanced index strategies – often delivered most cost effectively via ETFs – are putting active equity managers under even greater scrutiny.

“Smart beta strategies offer cheap, simple exposure to factors such as value, momentum, quality and low volatility, in an attempt to improve on market-cap weighted benchmarks. These systematic, factor tilted strategies now mirror what the majority of active equity managers, either deliberately or not, employ to generate alpha.

“The advantage of this development for fund selectors, is that they can now place active fund returns in a much better context. Under this lens, comparing a fund manager to the relevant smart beta strategy, the return profile of most active equity fund managers is likely to be diminished. The debate must now be whether active managers are replaced by these systematic factor based funds.

“The bottom line is active equity fund managers, with higher charges, should be able to beat the traditional market cap benchmark and the relevant smart beta strategy – otherwise what is the point in hiring them? But is there a place for active equity managers at all?

“As the competition has increased, we have seen the evolution of the ‘true alpha’ manager. This is a fundamental manager who understands the factors and the anomalies they are exploiting and has a process that can offer something much more than smart beta.

“A ‘true alpha’ fundamental manager can offer a differentiated forward-looking approach that is still rooted in an empirically backed style, but allows for the creation of higher conviction, high active-share portfolios of their 30-50 best ideas. Smart beta approaches cannot build concentrated portfolios; their reliance on historical data means they need to diversify away the probable errors created, often producing portfolios containing 1000s of stocks.

“While fundamental managers come at an increased cost versus smart beta, they should be evaluated in the context of the potential superior excess return that their forward-looking, higher-conviction offering can add.

“Institutional investors, in particular, may find that the marginal extra cost is outweighed by the potential for true alpha. A smart beta strategy may be more appropriate for the cost-conscious investor or areas where a superior active, fundamental alternative is not available.

“With the onset of smart beta, the industry no longer needs as many active equity managers or researchers to find them. True alpha is rare; we are able to screen out the vast majority of active strategies using this mind-set. If investors are paying active management fees, they should check that the managers they are using offer more than the systematic, cheaper alternative. It is time to focus on managers that are capable of delivering returns worth paying for and those that are not, will face extinction.”

Samuels’ views will carry weight as Redington advises over 60 clients that are responsible for over £350bn of assets.