Smart Beta: Targeted Solutions
An Institutional Investor Sponsored Report<br>Assets allocated to equity and fixed-income smart beta continue to grow dramatically, as investors deploy systematic factor exposures with a host of targeted solutions.
To view a PDF of the full report, click here.
Assets allocated to equity and fixed-income smart beta continue to grow dramatically, as investors deploy systematic factor exposures with a host of targeted solutions.
Smart beta asset growth continues apace, with global assets in strategic beta ETFs reaching $703.5 billion at midyear 2017 — a growth rate of 13 percent over 2016 year-end assets of $624.7 billion, according to data from Morningstar. Furthermore, the number of asset owners reporting an existing smart beta allocation has climbed to 46 percent, up from 36 percent last year, according to data from FTSE Russell. “Smart beta has become a default holding,” says Patrick McDonough, Global Strategist for Factor Investing at SSGA.
Growth in smart beta assets is coming from all segments of the market. Institutions, mainly large pension funds, have utilized factor-based solutions for decades, and these have now become standard, with broad adoption among midsized and smaller pension funds, endowments, and foundations. Many investors are adapting their asset allocation modeling to account for specific factors like value, momentum, and size, across specific asset classes such as equities, fixed income, and commodities.
“Over time, investors will change how they think about investing, from a traditional asset-class framework to a factor framework,” says Rob Nestor, Head of Smart Beta at iShares. Many investors are realizing that smart beta products are a better alternative to cap-weighted indexes, in terms of risk-adjusted returns, as well as an efficient alternative to active management. “Eventually, we’ll evolve to factors as a primary way to evaluate risk and return in the longer term,” Nestor says.
Inexpensive, transparent, and liquid, smart beta has become a serious challenge to active management. It’s also become a simple yardstick to measure and evaluate active performance, exposing those managers who are merely closet indexers, as opposed to those who do, in fact, generate true alpha. “Quite a few active managers — both quantitative and fundamental — have fallen short,” says McDonough.
Today there is much greater adoption of smart beta by traditionally active players. “We now see insurers, for example, on both the general account and asset management sides, who recognize that many of these concepts have been the basis of active strategies for a long time,” says Nestor. The difference is that smart beta is designed to capture specific well-known factors efficiently, with precision and transparency. “The concepts aren’t new, they just haven’t been framed as factors before, and they haven’t been so easily accessible,” he says. Investors who have historically relied on active management now appreciate the qualities of smart beta solutions, and they understand that they parallel the strategies their active managers have traditionally used.
With allocations to smart beta rising, investment solutions that utilize factor investing principles are growing and becoming more sophisticated. “There are a lot more vehicles in the smart beta, or factor-based, world, so it’s easier to find more targeted solutions to larger issues in a portfolio,” says McDonough.
Although equity smart beta receives the most attention, fixed income is catching up fast. Fixed-income indexes with debt-related weights are often concentrated among a small number of issuers, and early smart beta approaches reweighted them to equal weight; then, with more research and data available, they were reweighted to desired factors. “Now, we can define a factor and evaluate its pricing, which leads to more dynamic approaches, and it can deliver a systematic source of return efficiently,” says Riti Samanta, SSGA’s Global Head of Systematic Fixed Income. SSGA’s emerging-markets fixed-income smart beta ETF has been attracting assets from active managers. “Emerging-market debt typically has been an active space, but there is a lot of that opportunity set that you can offer in passive vehicles, and there’s been a lot of interest,” says Samanta. “There are still tremendous opportunities for pure alpha, but a material portion of returns in this sector can be systematized.” The key fixed-income factors have been identified as credit risk, term, and liquidity, which can be mapped to value and quality; yield; size; low volatility; and momentum.
On the risk spectrum of factors, quality tends to be lower risk and value tends to be higher. iShares recently launched an investment-grade fixed-income smart beta ETF that combines aspects of each. With a primary objective of outperforming the market, value is weighted higher than quality. “We have a proprietary methodology that blends them based on a probability-of-default model that we have developed,” says Nestor.
A high-yield portfolio, which is more focused on risk management, is also offered by iShares. “We find that most high-yield investors now are more concerned about the risk side of the equation,” says Nestor. Although they want to capture the yield, many don’t invest in high yield because of default risk. “It’s a risk-managed portfolio that, again, combines quality and value, but with a much greater emphasis on the quality side of the equation,” he says.
A Look under the Hood
Investors have learned that it’s important to look under the hood to fully understand the methodology behind factor index construction. “Construction matters deeply,” says Nestor. Construction techniques and methodology are important in terms of factor definitions, weighting, and other elements of product design. “It has to be clearly mapped to the research behind it, and reflect exactly what investors are trying to achieve,” he says.
If risk management is the primary goal, for example, it needs to be explicitly defined; so too, a focus on excess return. “In that case, investors have to decide how much deviation from the broad market they are willing to take to achieve it,” Nestor says.
One of the key defining features of smart beta is transparency. “Transparency is important, because it helps clients to be aware of exactly what tilt they are taking, what they are controlling for, and what level of control they have over various risks,” says Samanta. Each factor can be defined in a number of ways, and indexes can be assembled, weighted, and constrained in a number of ways. “It’s important to recognize that investing in factors is an active decision,” says McDonough. A clear vision of investment goals is needed to select the right combination of factors, and more diligence is required than with a traditional index. “You need to have the right implementation of those factors to ensure the best net outcome,” he says.
Overcrowding—when too many invest in the same securities, driving up values and reducing upside potential—is one of the general concerns about smart beta, particularly in the financial press. “Not to disregard the theoretical possibility, but the concept of overcrowding is probably the greatest source of misinformation about smart beta out there,” says Nestor. “Our assessment is that there is no risk of that today.” The main reason is that smart beta is just a small part of the investment world. “Our data show that it would take exponential growth, in some cases 40 to 50 times, for crowding to dampen factor premiums measurably.”
According to iShares data, the capacity for most factors, among U.S. equities, runs into the trillions of dollars. The factor with the lowest relative capacity, most susceptible to crowding, is momentum. “This is as expected, given its high turnover, but more than $300 billion could be traded in a week’s time before the premium would be eroded,” Nestor says. The aggregate active mutual fund universe in the U.S. is actually underweight to low- volatility stocks by $600 billion, according to iShares research. “That’s what it would take just to get back to square,” he says. “There is ample capacity here.”
“While there is more money targeting factors, most flows into smart beta were coming from active managers who were closet factor investors in the first place,” says McDonough. “There’s no particular massive shift causing the crowdedness of these factors.” The level of investment deployed to harvest factors is essentially unchanged; now it’s just an explicit exposure under the umbrella of smart beta, rather than an implicit one under the strategy of an active manager.
The industry could do a better job of simplifying the concept of factors by linking them to traditional asset-allocation models. “One of the challenges is a veil of complication,” says Nestor. “That’s not to say there isn’t sophistication in the index and product designs, but they’re based on familiar ideas.” Quality, value, size, and other factors map neatly into a framework with which investors are already familiar. For example, active buyers are replacing or diversifying their value managers with value-factor ETFs. “They recognize that it’s conceptually similar, and it’s a very effective way to access value at a much lower cost,” he says. Similarly, momentum links nicely to the growth box, a substantial component of nearly every portfolio. “If you look at the history of outperforming growth managers, much of that has been driven by momentum exposure,” he says.
Smart beta is evolving, and product innovation is well underway. Within equities, product design is becoming more refined to match investment objectives with more precision. “We’re going to see the recipes evolve around more discreet client objectives,” says Nestor.
Refinements and evolution of fixed-income smart beta are also well underway. “Factors play out across all asset classes, and we’re starting to see more sophisticated product development in fixed income and commodities,” says Nestor. “There are certainly going to be more products developed across the other asset classes that have not been built out today.”
In addition to new products, there will continue to be activity around deployment and implementation of smart beta as allocations continue to rise. “Implementation remains the number-one hurdle to broader use,” says Nestor. Investors understand the theories and concepts behind smart beta, but many aren’t sure how to move forward with it, given traditional asset-class frameworks. “We’re going to see a lot more development on helping investors think about implementation, whether it’s modeling or more refined portfolio construction,” he says. “That is our biggest focus.”
In fact, the view of a portfolio through the lens of factors is beginning to augment, if not supplant, that seen through asset classes. “In certain firms, factors are their new default,” says McDonough. “They were being hit by swings in factors anyway, and now that they’ve been identified and isolated, a factor-based portfolio could be more efficient than allocations to risk across asset classes.” Investors usually start with equity smart beta and move into fixed income, which leads to other asset classes, and some believe that factor combinations are a more efficient way to build a portfolio. “We’re doing more research on following factors across asset classes, and how it could change a portfolio’s characteristics,” says Samanta. — Howard Moore