Investors turn to smart beta and alternatives to navigate the scarcity of alpha in public markets

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Recently, 69 UK-based asset managers joined the SimCorp London Forum in the heart of the city’s financial district, where our Chief Product Officer, Marc Schröter, and Axioma’s Chief Revenue Officer, Brian Rosenberg, discussed strategies and approaches to address challenges in the financial markets.

“From an analytics perspective, one of the key points we would like to emphasize is the scarcity of alpha. We're seeing institutional investors continue to increasingly utilize passive mandates, alongside smart beta strategies, such as optimization and tilts,” Rosenberg emphasized at the start of the session.

Brian Rosenberg (left) and Marc Schröter (right) were interviewed by Dean McIntyre, Director of Strategy GTM Asset Management at SimCorp, during the London Forum.

A smart beta approach combines long-only passive investing with active strategies. Investors with long-term investment horizons, like pension plans and sovereign wealth funds, use these strategies as a systematic way to generate a higher, risk-adjusted return relative to traditional market-capitalization-weighted index investing. It incorporates intended exposures to a host of factors in order to diversify portfolios and achieve higher risk-adjusted returns. The most common strategies invest in undervalued assets (value), those with recent strong performance (momentum), high-income-generating assets (carry), and stable or high-quality assets (defensive/quality).

A 2023 report by investment consultancy firm Morningstar found that smart beta exchange-traded products amassed USD 161.2 billion in net new cash flows last year, translating to organic growth of 9.8 percent. Annual net flows were at a record high for two consecutive years, according to Morningstar.

Marc Schröter agreed that the increasing popularity of smart beta strategies can be attributed to the difficulty in finding alpha in public markets.

Uncovering Alpha is not merely a challenge; it frequently entails significant expenses related to analysts and quants, costs that only large institutions can bear in their quest for it. This scarcity alongside mounting margin pressures has put scrutiny on operational processes and the need to tighten up efficiency and total cost of ownership, while achieving the scale to seek opportunities.

“What is crucial in the context of safeguarding margins in an already tough environment, is the need for an industrialized approach, encompassing robust data, well-integrated systems, and seamless interoperability among various components, to ensure efficient operations,” Schröter said.

There will be substantial opportunities, particularly from an asset allocation perspective, to invest in alternatives. As the public markets become narrower, we see increasing opportunities to explore alternatives, especially in pursuit of alpha.

Brian Rosenberg, CRO, Axioma

Private markets continue to provide opportunities

As more institutional investors have adopted strategies based on style factors, forward-looking return estimates for these strategies may be less robust than their historical performance suggests. The saturation of these factors in the market can lead to increased crowding and, in some cases, higher valuations, potentially diminishing their future return potential.

To address this challenge and enhance the performance of institutional portfolios while diversifying their exposures, many investors have turned to private markets in recent years. These private market investments range from private equity, private debt and infrastructure to insurance-linked securities, forestry and farmland.

“There will be substantial opportunities, particularly from an asset allocation perspective, to invest in alternatives. As the public markets become narrower, we see increasing opportunities to explore alternatives, especially in pursuit of alpha,” said Rosenberg.

Many asset owners typically invest about 20-25 percent of their portfolios in alternative assets, and this allocation is expected to keep growing, making alternatives one of the fastest-growing asset classes.

“Interestingly, on the asset manager side, while alternatives represent around 20 percent of the total investable assets worldwide, they contribute a significant 50 percent of the revenue. This makes alternative investments appealing not only to alternative asset managers but also to traditional asset managers, particularly from a revenue perspective,” Schröter said.

While alternatives have traditionally played a significant role in institutional portfolios, the emergence of digital assets remains an area of cautious exploration due to their inherent volatility.

“We conducted a survey among our customers, and the results indicate that digital assets are still in their early stages. Ten to 15 percent of participants are actively exploring this space, with a few having already made investments, primarily among the largest asset managers. The primary motivation for entering this asset class appears to be driven by client demand and the potential for revenue diversification, rather than solely focused on returns," Schröter explained.

Data as strategic asset

A persistent challenge in investment management for decades has revolved around data management.

"Access to data architecture systems and vendor providers is essential for efficiently extracting and analyzing information. This data can drive insights for growth and operational alpha. Many asset managers are developing their data architectures, and in the future, we may witness operating models where vendors assume greater responsibility for data, offering comprehensive data architectures for complex datasets, thereby reducing the need for asset managers to build from scratch," Schröter explained.

“When we discuss data management we also need to think about alternative and unstructured data sources. At Axioma, we continually explore collaborations with partners in this space, in order to meet the needs of our clients. Interestingly, the data management conversation has moved beyond the process of sourcing, scrubbing, and normalizing data. What we are interested in is how we enable clients to gain access to deeper insights, through interoperability, so that they can accurately assess risk, construct smarter portfolios and make better investment decisions,” Rosenberg said.

We conducted a survey among our customers, and the results indicate that digital assets are still in their early stages. Ten to 15 percent of participants are actively exploring this space, with a few having already made investments, primarily among the largest asset managers.

Marc Schröter, CPO, SimCorp

AI to improve operations

Both Schröter and Rosenberg agreed that AI is becoming an integral part of our landscape and something service vendors and analytics providers must embrace.

“Major hedge funds have long been investing in machine learning, and this trend is unlikely to change significantly. However, what is indeed changing is the emergence of generative AI and natural language processing, which essentially democratize access to AI,” said Rosenberg.

Industry expectations have increased, particularly when it comes to user experience. The ease of using applications and the value they provide in terms of time spent are crucial. Integrating applications is one part of the equation, but what's equally important is the return on the time you invest.

“For example, if SimCorp and Axioma can seamlessly work together and promptly notify you when an investment violates compliance rules, or if there's integration between an Execution Management System (EMS) and changes made there instantly reflect in the Order Management System (OMS), and vice versa, this streamlining is essential,” Schröter said.

“At SimCorp, we have been working with AI and machine learning for years. We've developed our own models to quickly conduct internal testing to identify differences in various system versions of our investment management platform. We've also partnered with others to automate the processing of unstructured documents,” Schröter continued.

Historically, institutional investors have faced an operational challenge of manually extracting unstructured data from private market fund investments. This difficulty arises from the diverse nature of data associated with alternative investments, usually delivered in various formats, predominantly PDFs. By automating the data collection and extraction processes using machine learning techniques, investment professionals can allocate more of their time to value-added activities rather than engaging in the tedious task of manually copying and pasting basic fund investment information.

Another use case is within regulation, which plays a pivotal role in fostering growth for analytics providers. Whether it's MiFID II or UCITS reporting, offering services to clients allows them to embrace your products. Once they comprehend how you analyze their portfolios and assess risk, it opens the door to more informed discussions about the future.

“ESG presents an excellent opportunity, especially given the substantial regulatory framework. It's an exciting area for us to explore solutions that cater to these needs, report on them, and engage in in-depth conversations about whether ESG represents a risk factor. This engagement with our clients enables us to adjust our product roadmap and deliver the innovation that will meet evolving requirements. Regulation is a significant driver with vast potential for strengthening relationships with our clients,” Rosenberg said.

What to look forward to

The session closed with a simple question: What will excite you over the next few years?

Rosenberg pointed to four areas: ESG and data utilization, direct indexing and wealth, increasing accessibility to private markets, and the continued leveraging of technology, to improve operations.

SimCorp’s Schröter highlighted how cloud technology offers shorter feedback loops and enhanced scalability, providing better opportunities for the future.