From Theory to Practice
An Institutional Investor Sponsored Report
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Smart beta is evolving and a greater number of investors of all types are embracing and implementing risk factor-based techniques to solve specific investment concerns that help to achieve investment goals.
Smart beta has gone from theory to practice. Investors now have a much better understanding of the investment merits of risk factors and now an increasing number are looking at implementations and allocations. “There has been a lot of interest and education over the past couple of years, but now we’re seeing actual implementation in portfolios,” says Greg Behar, director of global equity investment strategy at Northern Trust Asset Management.
The market is still settling on an actual definition of smart beta, and the very term is still debated in the market, but at its heart is the concept of factor tilting, which explicitly allocates to a risk factor that has demonstrated a durable investment premium through time, versus index investing based on market-cap weighted indices. The most common, and acknowledged, factors are value, volatility, size and momentum.
These factors, or risk premia, have been academically researched, have been found to be persistent and can be extracted by building statistical models and index structures around them. “This suggests is that by tilting your portfolio towards one or more of these factors, you can capture that performance,” says Lori Heinel, chief portfolio strategist at State Street Global Advisors (SSGA). There are periods when individual factors out-perform market benchmarks, and there are periods where they underperform, but over time, they have proven to generate significant accumulative return premiums.
It’s catching on. “The recent growth of smart beta has been phenomenal,” says Dave Gedeon, head of research and development at Nasdaq Indexes. With the investors de-risking coming out of the financial crisis, there was a growing awareness among investors of the sources of risk. “Investors have become more intelligent about where they are going, and now seek out more nuanced exposures than simple broad small cap or broad market cap, for example,” he says. Investors also noticed that individual risk factors tend to behave differently than the broad market. “With smart beta, a number of opportunities to express a specific view of the market simply and intelligently emerged,” he says.
Investors are looking for transparent and repeatable strategies that they can access at reasonable fees. “Style strategies fit those characteristics,” says Ronen Israel, head of the global alternative premia group at AQR Capital Management. Increasingly, investors are trying to get transparent access to these sources of return and they are determining that smart beta, or style premia, can do that efficiently.
At the same time, investors have become more comfortable with the investment concepts. “They are recognizing what these things are and what they are trying to capture,” he says. They’re also recognizing that a lot of what active management has been providing is, in fact, these types of returns, just with higher fees, less transparency and more onerous terms.
“We actually see most investors turn to smart beta as a potential solution where they may have used an active manager in the past,” says John Feyerer, director of equity ETF product strategy at PowerShares. That entails a due diligence process that examines, among many other things, the value proposition, smart beta’s track record, the strategy and its durability. “Some are hesitant because many smart beta ETFs still have short track records,” he says. Most smart beta ETFs have three, four or five year track records, and due to the nature of rewarded risk factors, some may have underperformed recently.
Value is a good example. “There are factors that can have extended periods of underperformance, and it’s critical to understand the long-term time horizon that’s involved with these strategies,” Feyerer says. “Smart beta strategies are built on factors that, over extended periods of time, have shown to deliver value to investment portfolios.”
A new rewarded risk factor, or even a new tilt toward a factor, is very rare, because it is recognized only after it has been thoroughly researched and tested in academia to be durable and robust. “It has to be recognized and accepted as a beta, it can take 10 or 20 years to identify, research and test a new one,” says Eric Shirbini, global product specialist at ERI Scientific Beta. These recognized tilts are the most important, because there is academic evidence and empirical data that an economic rationale exists as to why investors would expect a return associated with this risk. “These aren’t characteristics found in a set of data that may disappear when everyone gets to know about them,” he says. “They’re actual, proven risks, that if you bear, you are going to see periods of underperformance, but over the cycle, you will be rewarded,” he says.
ERI Scientific Beta set out to provide investors to the recognized risk premia that academics have debated for ten years and longer. “When each one is researched, it is defined and measured in the same way, and it’s very simple measure,” says Shirbini. For value, for example, the academic definition is book-to-market.
Many smart beta providers adjust these measures and parameters to develop proprietary methodologies that may look better in back tests, but they deviate from the pure factor. “For value, we use book to market, which is the classic measure,” he says. Some are concerned about a concentration of leveraged companies with this standard measure, so they may simply remove them, adjusting the book-to-market standard for leverage.
Or some may think the definition is too simple, or suffered excessive performance during the financial crisis in 2008. “Value was supposed to have been risky in 2008—that’s what you’re being paid for,” he says. “As soon as you start adjusting the measures and creating a different set of companies, you don’t know if you have the factor anymore.” If the validation of smart beta is the academic evidence and rigorous testing that’s been going on for a decade or more, using a standard measure throughout, why go and change it? “If you use a single, simple measure to define the factor, and you are well diversified, then you get much more efficient performance,” he says.
“We already have a multi-factor index that combines all the different risk premia, because diversifying across them helps to reduce their risk,” says Shirbini. Innovative ways of using these as building blocks to fulfill their particular investor objectives have emerged. For example, some investors are concerned about a correction in equity markets, so they look for a smart beta strategy that is more defensive.
There are a number of fairly standard products, but each institution is going to have its own specific criteria, and it’s an exercise in designing a strategy using factor tilts as building blocks that are suitable to reach their goals. “It’s an exercise in how to use these indices in combination to give you what you want,” he says.
Much of the attention on smart beta has been on equity-focused, long-only, often single-factor strategies. “Those can be crude tools for sophisticated investors to use,” says Adam Berger, asset allocation strategist at Wellington Management. “These techniques become most effective when factors are combined, there’s a notion of timing to take advantage of factors that are attractive or unattractive at various points in the market cycle, and/or when they’re extended outside of equities to fixed income, for example, where the traditional bond indices are often less geared toward what investors are looking for.”
Another expansive move for beta-based strategies that is generating investor interest is alternative beta. In some cases, smart beta and alternative beta may be taking advantage of the same factor. “You can have a smart beta portfolio that’s long equity with a tilt toward value, or you can have an alternative beta portfolio focused on value that is long cheap stocks, short expensive stocks and market neutral,” he says. It gives a pure exposure to that same factor, but in the alternative space there are strategies that don’t have a counterpart on the long-only side. One example is merger arbitrage, when you are long the merger target and short the acquirer to get the exposure.
One of the reasons that smart beta strategies are compelling is that they’ve been replacing traditional market-cap weighted passive exposure. “Among the investors that adopt smart beta, many are taking a more thoughtful approach to passive exposure,” says Sarah Williamson, director of alternative investments at Wellington Management. Those that implement alternative beta strategies tend to be redeploying assets from traditional, long-only strategies to alternative investments and use alternative betas as a complement to these alternative allocations. “In many cases, it’s more efficient to implement these exposures through an alternative beta approach, because it’s cost effective, or the capacity is available and it can be done quickly,” she says.
Over the past year, there’s been an evolution. Now, investors are much more focused on how to implement, where it fits into portfolios, and how it performs in different market regimes. “We’ve moved away from discussions over what it should be called, how best to define it and what it does and doesn’t do,” says Sara Shores, global head of smart beta at BlackRock. Investors are thinking about very specific implementation questions. “For example, they may want to improve returns by 50 basis points after fees or add 10 percent downside risk protection to the portfolio,” she says. “Once they have outlined the outcome they are trying to achieve, we can think about how to put these tools together in such a way to achieve it.”
In addition to beating the broad market, each investor has a unique set of goals and objectives for smart beta strategies to address: income generation, risk management, different time horizons and governance issues, for example. “They’re looking at applications of factor-based strategies as tools to engineer their portfolios to meet unique goals and objectives,” says Behar.
The next step is to determine which factors will do the job and how to combine them in an efficient, effective way. “For example, a low-volatility strategy can help to preserve a defined-benefit plan’s funded status,” he says. “We implement that by combining it with quality to improve the consistency of returns and mitigate periods of underperformance.”
Using smart beta can result in a very different portfolio exposure. “For example, considering how a managed-volatility equity portfolio drives overall risk at the portfolio level, you can actually maintain a higher allocation to equities and have the same standard deviation or volatility in the total portfolio,” says Heinel. Smart beta provides ways to capture the premium as well as shape the risk attributes of the portfolio in a way that classic market-cap weighted indices don’t.
There’s not one optimal factoring investing solution. “The optimal factor investing portfolio is client specific, based on the stated investment objectives,” says Joop Huij, head of factor investing research at Robeco. For example, a pension fund, which has liabilities, will be quite different from a sovereign wealth fund and each will view interest rate risk in different ways. If interest rates go up, it helps the pension fund, because its liabilities will fall. “But this could be bad news for a sovereign wealth fund, as inflation, which is the target that it wants to beat, could rise,” he says.
“Smart beta works best when investors understand the rewarded risk factors they want exposure to when approaching implementation,” says Feyerer. “They can then create simple portfolios that address these in a way that makes sense.” In some cases, it can replace active management. Smart beta strategies may provide similar exposure but in a more cost-efficient and tax-efficient way. If an investor is seeking greater returns than benchmark performance, there are opportunities to add potential incremental return without necessarily taking on additional risk. “On the flip side, if the investor’s objective is managing overall risk and volatility, and they’re truly interested in maximizing return per unit of total risk, low volatility strategies can work well,” he says.
Relative risk is an important issue for investors to think through. “It can be tough in a bull market,” he says. Investors have to decide how comfortable they are with periods of underperformance versus a benchmark index. “Those types of conversations help to guide the deployment of smart beta to provide solutions,” he says.
Another trend, which ultimately may be the most important, is that a greater number of investors are thinking increasingly in terms of the goals or the outcomes of their portfolios,” says Heinel. Liability-driven investing (LDI), which is explicitly managed to match a fund’s assets to its liability stream, is an example of this concept. Managing drawdown risk, income levels, terminal value or inflation are other goal-oriented approaches that smart beta can address. “You might make some different choices when looking at a portfolio through the lens of a particular goal,” she says. Most clients are concerned about overarching portfolio risk and managing volatility. “The idea of tamping down volatility through a managed volatility equity exposure, for example, really resonates,” she says.
“We Need to Own IBM!”
There are a lot of hairs to split in defining the systematic capture of investment risk attributes, and what the market is recognizing as smart beta. “Smart Beta simply means rules based,” says Tom Dorsey, founder of Dorsey Wright & Associates, now part of Nasdaq, and CEO of Dorsey Holdings, acknowledging that most define it as tilting toward risk factors and not market capitalization. “How can it otherwise be smart unless someone has actually considered the rules to make it a systematic process?” he asks. Smart beta takes someone’s instincts about investing and turns it into a rules-based strategy, taking emotion out of the process. “Our firm has rules-based facilitators, not portfolio managers, and not one has a hunch or does analysis and, having an MBA, scrutinizes the fundamentals and says, ‘We need to own IBM.’”
“Smart beta is basically index investing with a non-market-cap weighting,” says Gedeon. Tilting the weighting of a core benchmark index results in its altered risk and return profile. “You can screen based on acknowledged investment factors, various fundamental ratios, or use equal weighting,” he says. “Those aspects can be blended together to produce a specific risk and return profile that will define an investment objective.”
From there, the definition becomes more refined. “I believe it is helpful to look at smart beta through two lenses, a factor-based lens and a ‘common ingredients’ lens,” says Feyerer. The first views smart beta through its exposure to rewarded risk factors such as value, low volatility and momentum. The second lens evaluates smart beta through its common ingredients or characteristics, which includes the formulaic rules-based methodology upon which it is based, its transparency, non-market-cap weighting. The critical element of systematic rebalancing is within that framework also.
Whether it rebalances back to a factor weighting mechanism or an alternatively weighted methodology, the key is that it happens through a built-in, fully objective, rules-based discipline that sells stocks that no longer fit the criteria and allocates to those that do. “Smart beta assures that investor emotion is removed from the equation,” he says. “Even when fear dominates market sentiment, the rebalancing process is systematic, based upon formulaic criteria, and not reactions to short term difficulties.”
It evolves from there. “Our view of so-called smart beta is based on a spectrum of factor and style investing, says Israel. The spectrum spans long-only, single style and single asset classes, such as equities, all the way up to long/short, multi-style and multiple asset classes. What most regard as smart beta, fundamental indexing, for example, sits on that spectrum. “Fundamental indexing is really a value tilt around a benchmark portfolio, which is a valuable source of return,” he says. “But we would also think about value in combination with other sources of return as being valuable as is implementing styles in multiple asset class contexts.”
Rather than risk factors, AQR refers to styles and style premia. “These are the systematic, classic sources of return that have the empirical evidence and economic intuition to back them,” says Israel. They are grouped differently than the classic smart beta risk factors as well, and they include: value; momentum; carry, which includes dividends; and defensive, which includes low risk, low beta, and high quality. “Most of the widely acknowledged risk factors fall into one of those buckets,” he says. The idea of style premia recognizes a broader implementation of systematic sources of return along that spectrum.
A whole category of strategies in alternative beta is carry based, which in some sense, area status quo trade. “If you are long higher-yielding stocks, currencies or bonds and short lower-yielding ones, you’ll have a positive return for that position, assuming the rest of the world stays the same and nothing changes in the valuation of those elements,” says Berger.
Smart beta is grown by becoming more multifaceted. “We think of smart beta as long exposure to an asset class with a tilt to a desired profile, such as low volatility, value, momentum and growth,” says Williamson. “The tilt is adding another dimension to the long exposure, which is one reason investors use it in portfolios as a tool.” “In contrast, we define alternative beta as exposure to a return source that’s not linked to the direction of the market, which makes it a more powerful diversifier.” That could be a balanced long/short portfolio or one that varies its market exposures over time but has no net long exposure on average.” The concept of smart beta is evolving and extending as well. “While much of the focus has been on the equity side, there is more potential in fixed income and alternative betas,” says Conor McCarthy, director of client investment solutions at Wellington Management.
Getting More Juice
The market has moved from an early adopter mode to more investors actively considering smart beta as an effective tool that has unique and attractive attributes. “Most of our client meetings involve a discussion about smart beta,” says Heinel. Many are frustrated with poor returns and want to see their core portfolios work harder. “Our clients are asking how to get a more juice out of it while keeping the low fees and transparency of passive management,” she says.
In addition, there is continued frustration with active managers, many of which have seen lackluster performance while charging relatively high fees. “By using multiple active managers, in many cases asset owners end up with a portfolio that has significant coincidental factor tilts,” says Heinel. They can often replicate those characteristics with a low-cost smart beta strategy and use only a limited number of active managers to generate pure alpha.
Active managers are not going away, but smart beta is clearly putting them on the defensive. “If active management is defined as portfolio managers who actually make day-to-day decisions on what to buy and sell, then they will find that automation will overtake them,” says Dorsey. “With technology developing so rapidly, if an active manager isn’t thinking about developing systematic strategies that are automated, they’re whistling past the cemetery.” Indeed, the growth of ’40-Act funds demonstrates that many quantitative managers are adapting their strategies into systematic, indexed vehicles for the broader market. “By 2020, the ETF will have passed the actively managed mutual fund like a rocket,” he says.
This is causing investors to evaluate their portfolios on a risk factor basis, and they can be surprised by what they find. “When investors analyze their active portfolios from a factor perspective, they can find that they look a lot like a market cap-weighted index, but at a much higher fee,” says Behar. Or they find unintended risks or those for which they aren’t compensated. “A pension fund that would like lower volatility to preserve funded status might find itself inadvertently overweight high volatility stocks when it analyzes its active managers’ exposures,” he says. Increasingly, they’re looking at their portfolios in these terms and they want tools to align with their objectives.
However, smart beta tools can be useful to active managers. “This could be the rebirth of active management,” says Shores. Just as an active manager will have a view of being overweight Japan and underweight technology, for example, why not have a view of being overweight momentum and underweight quality or short interest rates and long inflation in a particular period of time. “Those exposures are a source of return, but you should pay active fees for them only if there are insights attached,” she says. The static average exposure is something that can be delivered more cost effectively through smart beta strategies.
“Timing these factors is the new frontier in investment research,” says Gedeon. On a risk-adjusted basis, certain factors have outperformed the market, as well as other factors, over time. “They have been identified, and the new question is how to take best advantage of them, and also how to time them,” he says. For example, momentum doesn’t always outperform, but it tends to, and has over the past 40 years on an annualized basis. “That’s pure alpha that’s been generated,” he says. “But we want to know when momentum will not outperform, and harnessing that will be the new alpha.”
While the business models of some active managers may be under scrutiny, the truth is, smart beta is an active proposition, and there is an enormous amount of judgment, even when implementing a rules-based transparent process, in the whole practice. “Simply to pick the best value stocks means defining value in a specific way,” says Heinel. Value based on what? Price-to-earnings, price-to-book or something else? “The determination of how we’re going to extract the factors, the weighting schema that we’re going to apply to the factors and the universe we’re going to apply it to requires a lot of judgment calls,” she says.
Smart beta also means that investment staffs are taking strategic and tactical decisions in-house, away from the realm of active management. Before, if the fund was underperforming, the active manager would explain the market conditions and relative benchmark performance in order to justify the fund’s returns. When smart beta underperforms, it’s usually known and part of a long-term strategy. “The choice now resides more with the asset owner, and there’s a lot of cyclicality in how these factors perform,” says Behar. “It’s an active decision, implementation and ongoing strategy.”
It’s a misperception that smart beta is passive. “It’s fundamentally active in the sense that it’s different than the typical cap-weighted benchmark, and the decisions that are made to construct the methodology and implement it will drive results in very different directions,” says McCarthy. These decisions, both in defining the exposure and in implementing it, are key to whether an investor’s objectives will be met or not. It’s an exercise in applying smarter exposures as well. “For example, in a low-volatility strategy, we combine smart beta, alternative beta and alpha together to achieve a better outcome for clients,” says Williamson. “We combine beta elements in a way that adds value, then we add alpha, in the strict sense of the word, as the actively managed portion of a portfolio.”
This is leading to investors beginning to change their basic thinking and, as a result, the way they view their portfolios. “Increasingly, particularly among institutional investors, we see investment staff working to build more resilient portfolios that have a broader, more strategic, long-term view,” says Israel. It’s not about short-term responses to whether a particular manager is doing well or not. It’s more about a long-term strategic viewpoint and allocation to a set of returns. “Once investors start to think about their long-term goals in that way, they end up with better investment behavior, because they have a realistic view of how the sources of their returns really perform in different market environments,” he says.
The Alchemy of Combined Factors
Smart beta providers are using more sophisticated, although not complex, combinations of factors to solve specific investment issues. “There is a considerable interest in multi-factor strategies, but keeping the methodology very simple and transparent,” says Feyerer. For example, PowerShares recently launched FXEU, a low volatility European equity portfolio with a currency hedge. “The underlying S&P Eurozone Low Volatility USD Hedged Index starts with a universe of 950 stocks reduced the list to 80 least volatile companies and layers on a currency hedge to reduce that risk,” he says. For yield-seeking investors, a high-dividend portfolio combined with low volatility has worked well. “Those strategies that have demonstrated strong asset growth and the most interest have been those that can be reviewed and evaluated very quickly,” he says. “The more simple and transparent, the better.”
The first question is which strategy to invest in, and most consider a multi-beta solution. “Instead of placing all your eggs in one kind of beta, it’s best to diversify,” says Shirbini. All of ERI Scientific Beta’s listed products are multi-beta products. “The majority of investors that have adopted our indices, have chosen multi-factor, or multi-beta, approaches,” “The one we find the most popular is our oldest, a four-factor index, which includes value, momentum, a size and low volatility,” he says.
Increasingly, investors are looking for multi-factor strategies, in which timing risk can be mitigated and the tracking of the overall portfolio versus established benchmarks can remain within a tolerable band. There are different techniques, with some smart beta providers combining factor indices from a top-down perspective, and others building from the bottom up by assessing factor attributes to individual stocks.
“We’ve recently done some research where we demonstrate that assembling the factors in combination gives you a better portfolio than then combining them from a top-down perspective,” says Heinel. In the first case, for example, a client might want three factors in its portfolio, and they might allocate one third to low volatility, one third to value, and one third to quality. “You’d effectively combine those portfolios, and because they had low correlation through time, you would smooth out the returns to the portfolio, and you would still capture the premium,” she says. The other way is to create a portfolio from the bottom up by identifying those stocks that have all three attributes and overweighting those that have a combination of low volatility, attractive valuation and high quality. “Our research shows that that there was a fairly sizable premium to be had by looking at those three factors in combination,” she says.
By contrast, to offer investors a multi-beta solution, ERI Scientific Beta creates a separate index for each and blends them together. “It is very important to create separate single risk-premia indices and then combine them instead of doing it at the stock level, because premia at the stock level creates too much company-specific noise,” says Shirbini. “When combining signals at the individual stock level, you don’t have a clue what you have in the end.”
There has been significant research on which factors consistently work, and combinations of low volatility, value and momentum tend to perform for most smart beta applications in a variety of market conditions. “Historical returns show that each of these factors can lag the market for long periods of time,” says Huij. To overcome this, diversification is key. “You need to diversify across these premiums by combining these factors,” he says. It’s a challenging task for several reasons. “These factors diversify really well, but when combined, they can cancel each other out,” he says. Optimizing the end portfolio is can make sure that combined factor strategies work together. However, optimization usually happens at the manager level, and it should happen with a holistic view at the client level. “If a client’s managers do their own optimizations, the client might end up with a sub-optimal portfolio,” he says. For example, when combining value, stocks with low returns, with momentum, stocks with high returns, you can end up with something that resembles the broad market index. Furthermore, a smart beta strategy should be evaluated not only for the outperformance it will generate, but for the interaction it will have with the total portfolio.
Investors are looking more closely at the best way to structure these strategies in their portfolios. “They’re looking more closely at the finer detail, and in doing so, there’s a greater emphasis on craftsmanship— the nuances between different implementations and how to capture these returns in the most efficient way possible,” says Israel, “and we’ve found that the most effective way to put a portfolio of styles together is in an integrated fashion.” This means building a portfolio that incorporates specific styles while trying to capture synergies and natural netting effects that occur as the styles interact with one another.
For example, a value strategy tends to perform better over time when combined with momentum, and making a separate allocation to each would generally improve the overall portfolio. “But you can take it one step further and build a more efficient portfolio that integrates the two, because you can capture the netting benefits,” says Israel. The cheapest stock and the most outperforming stock are not always the most desirable. “The stock that might be the most powerful in this strategy is the one that looks best in combination which might mean cheap but not the cheapest and outperforming but not the most outperforming,” he says. Sometimes the cheapest stock is the worst performer, and as those two attributes are offsetting, you can lose the netting benefit when you invest in two separate investment vehicles. “One owns it, and one sells it, so you don’t get the benefit of that netting that you get by directly integrating the two,” he says.
“Combining factors is ETF alchemy,” says Dorsey. “H2 plus O equals water.” Likewise, combining a momentum strategy with a low volatility strategy, for example, creates an entirely new product. “Momentum is the engine, and low volatility is the brake,” he says. Momentum and low volatility combined acts differently than the two single strategies working in tandem. “It’s critical to understand that,” he says. A good example of combined factors in a multiple asset class vehicle is DWA’s DALI (dynamic asset-level investing) tilt strategy. A client’s specific risk tolerance level determines the minimums and maximums in various equity and fixed-income categories. “We allocate the minimums, then allocate what’s left tactically to the maximums, based on an investor’s risk tolerance level and the performance of the category, like US mid-cap equities or emerging market sovereign bonds, with regular rebalancing when the tactical approach suggests a switch in the underlying investments,” he says. This is different from modern portfolio theory rebalancing. The minimum allocations stay the same, but the maximums are going to change based on risk tolerance and market performance.
Making Smart Beta
Work in Real Life
“There’s ample evidence that smart beta strategies can generate outperformance, but most implementations are suboptimal,” says Huij. It’s necessary to understand why these factor premium patterns are there and that understanding should be part of the investment process. “For example, there is a correlation between the risk in a value strategy and the potential higher returns, but there is no empirical evidence of a relationship between actually taking the risk and earning the higher return,” he says. “This means that if you follow a generic value strategy, you will be exposed to risks that are not necessarily rewarded.” This concept is also consistent with the low volatility factor. “It’s very difficult to attribute this low volatility anomaly to risk because you’re taking less risk,” he says. The way to make a factor investing strategy more efficient is to identify clearly the risks to which you are exposed when following a strategy and deciding on a technology to take out those that are unrewarded.
“The most important thing to understand with any smart beta strategy is the actual exposure that is delivered,” says Shores. “The choices that you make in portfolio construction have a very large impact on the exposure that’s delivered and the outcome that’s achieved.” Do you constrain sectors and countries relative to a parent benchmark? What is the starting universe for security selection? Does it include small-cap securities or just large- and mid-cap securities? How often do you rebalance? These considerations have a major impact on the exposure that’s delivered. “Understanding the nature of the exposure helps us to understand the role it is likely to play in your portfolio and how it will perform in different market environments,” she says.
“Design matters and all factor-based strategies are not created equal,” says Behar. For example, some indices may claim to be high dividend or low volatility but they also come with interest rate sensitivity or a bias toward growth or leverage that may be unintended and not compensated. “A lot of these strategies come with large sector biases, so you have to examine what is really driving returns,” he says. A dividend strategy, for example, may be overweight utilities and underweight financials and technology. If interest rates go up, utilities, which have high payout ratios already, don’t have economically sensitive revenues, and their results could be negatively affected. A technology company flush with cash might increase or initiate dividends, while financial companies tend to do well when interest rates go up. “An investor may be surprised by how it ends up performing,” he says. “Through thoughtful portfolio construction, it is possible to get higher dividend yields without having those sector biases.”
There’s a proliferation of off-the-shelf smart beta indices. “How do you evaluate them for efficiency, intended factor biases and those that are unintended?” asks Behar. A number of indices have similar names—risk weighted, low volatility, minimum volatility, defensive—but on closer examination of the construction and methodology, it’s clear that they can perform very differently in different market conditions, and they may not perform as advertised.
“Academic studies typically ignore things like trading costs,” says Huij. They also ignore restrictions like shorting. “Shorting can be very expensive, and it’s important to consider the effects that shorting can have on returns in a factor investing strategy,” he says. Another market concern is the impact of crowding. “Investors are putting a lot of money in these strategies,” he says. “We already see some meaningful consequences for particular stocks being so popular,” he says. As their prices are pushed up, their characteristics and role within a factor index changes.
“We know how these factors behave, but the manner in which you capture and integrate them in portfolios is critically important,” says Shores. For example, just getting rebalancing right is an exercise unto itself. “Is it monthly, quarterly or semiannually? A more frequent rebalance might result in a more pure exposure, but it will incur far higher trading costs, which might erode the benefits. “Having a realistic view on capital market conditions, trading costs, the impact of risk return and costs simultaneously is critical when you’re building these portfolio construction rules,” she says. Once the rules are written, they are followed to the letter, so it’s imperative to get them right.
Correlation across similarly structured smart beta strategies can become an issue as well. “If you use a definition of value that is identical to everyone else’s, it can become a crowded trade,” says Berger. “You may be less differentiated than your peers and less diversifying than you expect.” Therefore, the strategies are recognized as active, and a lot of analysis goes into how each exposure is defined, how different exposures are combined, and how the strategy is implemented and rebalanced over time. Furthermore, in some cases, a strategy’s transparency can work against it. “Some of the larger funds that have a clearly described methodology can be front-run,” says McCarthy. Trades and re-balancings that are known can be traded on in advance. In some ways, the more index-like a traditional smart beta strategy is, the less valuable it is to an investor, because if everyone knows your set, transparent rules and how and when you rebalance, people can anticipate it and take advantage of it, says Berger.
Smart beta providers each identify fixed income as the next frontier to apply risk premia and alternative weighting methodologies. But applying smart beta methodologies to the bond market can be challenging. In February BlackRock launched the Fixed Income Balanced Risk ETF. “We started by thinking about what drives returns in bond markets, and what is the most important decision that a bond market investor can make,” says Shores. The two most important things in fixed income are interest rate risk and credit risk, and the amount of those exposures in a fixed-income portfolio will govern the vast majority of the total return. “We wanted to make sure that we got those two things right,” she says. With interest rates expected to rise, investors are seeking less interest rate risk. “Now they’re worried about more about the amount of duration their portfolios and how that might impact their future returns,” she says, “and we wanted to provide a better diversification of interest rate and credit risk in an index-based portfolio.” That allows for a more attractive risk profile while still earning a reasonable yield.
Constructing the portfolio wasn’t an easy process, however. Researching and back testing fixed income is inherently more challenging than equities. “Just getting your hands on the pricing data for these OTC securities is a significant undertaking,” says Shores. Liquidity is an issue as the ability to source bonds is significantly more challenging. “That’s part of the reason why at last count you see more than 700 exchange traded equity smart beta funds but only nine for fixed income,” she says.
Where Are We Heading?
“There will be continued innovation and even more productive solutions that improve results for clients,” says Shores. A lot of that has to do with empowering investors to understand what they own and what they should own, which gives us a better understanding of how best to implement these ideas in portfolios. “This factor-based view of the world that’s focused on the true drivers of return empowers investors to better understand their portfolios and to better achieve their desired outcome,” she says.
Most agree that there will be more innovative applications of smart beta strategies. “We’ll begin to see these ideas applied in long-only portfolios in other asset classes like fixed income,” says Israel. But there’s no reason to stop at long-only equity investing. “We’ll also see them applied in long/short portfolios in other asset classes and in diversified multi-strategy implementations,” he says. For those who believe in value as a style in equities—overweight the cheap and underweight the expensive—that concept is easy to translate by going long the cheap and short the expensive. One can then extend that same idea to other markets, where cheap and expensive are just defined differently. “The notion of long only equity investing is well established, but the philosophical foundation for it is one that exists in other asset classes,” he says.
By Howard Moore