Smart Beta on the Move (Americas)
Smart beta strategies continue to grow as an increasing number of investors recognize that risk factors and style premia are long-term, persistent sources of return. While a definition around rules-based, passive implementation is taking hold, many providers are building dynamic strategies that are based on systematic frameworks. By Howard Moore
“It was a great year in 2015,” says Lynn Blake, chief investment officer of global equity beta solutions at State Street Global Advisors (SSGA). Total assets grew by 9 percent in the US, reaching more than $566 billion in December, according to Morningstar. European growth was more dramatic, with a 29 percent rise and assets reaching $41 billion. The investment thesis of capturing risk factor returns in a rules-based systematic way is gaining much wider traction, and investors are embracing the concepts in a much more sophisticated way as well. “As investors begin to understand how smart beta works, the difference we see now is less interest in single factors strategies, and much more in those that are multi-factor,” she says, referring to those that blend risk factors for greater diversification, downside protection, and the potential for better risk-adjusted returns.
Smart beta is a term used to describe systematic, rules-based factor investing, which explicitly allocates to securities that demonstrate the properties of acknowledged factors. Grounded in academic theory, tested and proven to have generated durable investment premiums through time, the most common and acknowledged factors include low volatility, size, momentum, and value. Smart beta is usually implemented passively, using indices tilted toward specific factors, typically single but sometimes in combination, and is distinguished from indices that are weighted by the market capitalization of the underlying securities. It gets more sophisticated from there, and some providers use a broader set of styles to extract return premia. They are implemented differently than the classic smart beta factors as well, and include value, momentum, carry and defensive, which itself includes low risk, low beta, and high quality. The idea of style premia recognizes a broader implementation of systematic sources of return along that spectrum.
Alternative beta strategies are pure plays on factors, detached from the direction of the market and from each other. They can be combined flexibly with traditional market betas and alpha sources for different objectives. Their low correlation to markets and to other factors make them potentially valuable building blocks for constructing more effective investment portfolios. This is true for exposures in equities, fixed income and increasingly in absolute-return oriented alternative beta strategies that include factors like value, momentum, and carry.
“There’s a lot of steam gathering behind smart beta assets,” says Dan Draper, managing director of global ETFs at Invesco PowerShares. They’ve had a 25 percent annual growth rate over the past three years, compared to about 11 percent for the broader ETF industry. “It’s an amazing development when you consider that many of the world’s largest fiduciaries that use ETFs are benchmark-constrained, and for them to reallocate and tilt the portfolio with factors demonstrates remarkable interest in the strategies,” he says.
“There has definitely been more interest and increased adoption,” says Conor McCarthy, director of client investment solutions at Wellington Management. One positive byproduct of smart beta is that investors of all types are thinking of risk exposures more thoughtfully and now have a heightened level of awareness with the whole notion of factors and how they impact a portfolio.
“We definitely see increasing interest, pretty much across the board,” says Ronen Israel, principal and portfolio manager at AQR. “More people are thinking about their portfolios and allocations from a style perspective and moving from traditional active management to get exposures to these types of returns in ways that are more efficient, transparent and at a fairer fee.” It comes in several different forms, including the long-only, single-style equity strategies, which is what most people refer to as smart beta; the long-only equity, multi-style versions; and there are the long/short multi-style, multi-asset class versions as well.
Historically, growth- and income- oriented strategies have attracted the most assets, but now the established industry-consensus factors—value, small cap, momentum, quality and especially low volatility are coming into their own. “Overall, there is a movement among investors who in the past would have followed styles—value, growth, large cap, small cap, sector and region—are now allocating risk more precisely through factors and producing better outcomes. “Low volatility and quality have been attractive places to be in the last three to four years,” says Draper. This has been especially true since December 2015, when challenging earnings announcements and estimates were announced. “A lot of investors want to own the highest quality companies, which are generally evaluated by the income statement, balance sheet and cash flow metrics,” he says.
Others agree. The past year has seen the greatest interest in low volatility and the combination of low volatility with momentum and low volatility with quality. “Tilting toward low beta stocks is not a big surprise when the market becomes volatile and investors start to look for downside protection,” says Blake. However, most of the growth has been in two-, three- and even four-factor strategies. “The benefit of multi factor is diversification,” she says.
On the long-only side, there recently has been some increased interest in defensive strategies. “That could be because of recent market volatility,” says Israel.
Investors are looking to capture the risk-adjusted return advantage of those strategies, which hold safer, lower risk securities and can still generate equity-like returns. “Similarly, we see increased interest in diversifying sources of return, as well as long/short strategies, which are also uncorrelated, ” he says.
In the current market environment with likely sluggish equity returns, slow growth, low inflation, and probably limited policy tightening, there is likely more risk to the downside. “It’s looking like a pretty choppy ride ahead,” says Blake. These multi-factor strategies can be a way to get more from the core, standing in for some traditional cap-weighted passive investments. “In these markets, value and size tend to perform relatively poorly, while low volatility, quality and even momentum can perform well, so having those factors in your portfolio, along with a little bit of value, which is a pretty cheap trade right now, is a nice diversifier,” she says.
Active, Passive and Dynamic
Some believe that smart beta is a threat to active management. Historically, the appeal of moving away from traditional active strategies was reflective of the underperformance and high fees of active managers. “But now we’re seeing more sophisticated analysis across active portfolios that shows strong index-like characteristics with tilts towards size and value,” says Blake. “We find that many active portfolios have relatively low active risk, and as a result, limited alpha potential.” A factor-based, smart beta portfolio can replicate those types of exposures more efficiently with lower fees. As a result, investors have a better understanding of what really drives their portfolios’ performance and what it should cost. They are looking for where they can replace factor exposures with smart beta strategies and search for managers who can deliver true alpha and real outperformance. “Overall, that will generate better returns and be a much better value,” she says.
Some of the smart beta approaches select securities based on specific criteria, weight them according to strict methodologies and rebalance once a year, with no deviation. “They may be based on indices over very broad universes that are not really implementable, for example, and which may not really control for time-varying risk exposures,” says Israel. One simple example is the rules-based Fama-French factors. “They build portfolios that are dollar-long, dollar-short, but dollar-long, dollar-short isn’t always market neutral—it depends on the market exposure, or beta, of your long side versus your short side,” he says. At times, they can take on tremendous market exposure which is not what they intend to do. “When you start with a rules-based concept, these types of issues are going to crop up,” he says.
“We don’t rebalance on a set schedule—we rebalance when the portfolio you would build today is sufficiently different than the portfolio you currently hold,” says Israel. There are periods when there is a greater need to rebalance to maintain the portfolio’s characteristics. Some of these factors can be affected by market volatility and other changes, and when the underlying holdings have changed significantly. In a multiple style context, for example, the weighting of the styles must be maintained. “Market changes may trigger rebalances, versus just waiting until the next scheduled rebalance,” he says. “We’re not going to deviate from a systematic framework—but even within that systematic framework there’s still going to be a dynamic element which allows us to more effectively capture these ideas.”
“The whole notion of factors is changing for the better the way that institutions build active portfolios in general,” says Adam Berger, asset allocation strategist at Wellington Management. Investors have a greater awareness of what factors are at work in their portfolios and what factors are driving the portfolio over time. “It’s partly about identifying overweights, areas where you have too much exposure to a single factor, and underweights, factors that in theory could be diversifying and sources of new return that you’re not adequately exposed to,” he says. On a strategic level, it’s about getting that balance right, and on a tactical level, managing it. That could be as simple as a rebalancing rule, but it also might extend to making tactical tilts in your manager lineup or in factor exposures to take advantage of opportunities in the market. “We spend a lot of time looking at what we call risk factor outliers, which is a whole different avenue of strategy development that takes advantage of opportunities that come up where one particular risk factor, maybe in a single sector or country, for example, becomes particularly cheap and represents a buying opportunity—or on the flip side, gets expensive and represents a selling opportunity,” he says.
After the financial crisis, investors are more focused on transparency and fees—asking if they are paying the right fee for what they’re getting. These strategies capture the same long-term sources of return, but in more efficient ways. “This all supports the smart beta-style premia type strategies, which are transparent by design,” says Israel. But even more important, the economic intuition and the sources of return are very transparent. “It’s not about hiring a specific manager and their magic—or idiosyncratic skill—which often can be a nontransparent idea, it’s about building portfolios that seek to capture clear and economically intuitive ideas,” he says. “Because these are systematic sources of return, versus idiosyncratic, they should come at a fairer fee than active management.”
Index and Portfolio Construction
Smart beta strategies can still leverage a single factor, but because they’re generally not correlated to one another, when combined, the diversification helps to drive higher risk-adjusted returns over time and eliminates issues of timing and market cycles. “We did see outflows in value-tilted strategies,” says Blake, which is not surprising given the current market environment. “It’s not the best time to sell when at a low,” she says. Long term, the value factor has experienced excellent excess performance, but to achieve it, an investor needs to be in for the long haul. “We encourage our clients to stick through the tough periods,” she says.
Any portfolio manager would acknowledge that timing factors in the short run is nearly impossible, just as market timing is nearly impossible. There certainly are periods when factor pricing and valuations relative to historical numbers can be an indication—although not a prediction—of when to buy and when to sell,” says Blake. Low volatility stocks, for example, look a little expensive in the current volatile market, and quality stocks look a little cheap. Factors like momentum, size and value look well-priced. “That’s one element to building top-down strategies that try to give exposure across many factors,” she says. “The idea is to create diversified portfolios across factors with a long-term horizon to capture any sort of associated risk premia, because timing is so challenging.”
There are different techniques used to build them. Factors can be equal-weighted, against low volatility, low valuation and high quality, for example, as in SSGA’s multi-factor SPDR MSCI Quality Mix ETFs. SSGA also uses a proprietary strategy that evaluates stocks across three factors, tilting toward those that have the highest scores while underweighting those with the lowest. In December 2015, SSGA launched three Russell 1000 Focus factor funds developed with the Alaska Permanent Fund. “It was a collaborative process,” says Blake. All three of the multi-factor ETFs have the same diversified base exposure, which is a combination of value, quality and size, but each has an additional factor overlay of yield for income generation, volatility for drawdown protection, and momentum for growth. “Investors can trade among the three US equity multifactor strategy depending on their objectives and the market cycle,” she says.
Once the methodology is determined, an index does not have any judgment that goes into its construction or how it evolves over time. “It’s actually perceived as a positive if a smart beta strategy stays static and the rules never change and if it is completely transparent,” says Berger. But moving away from that paradigm by having some flexibility to adjust and allow the rules to evolve over time can result in more durable portfolios. “In most cases, an index is fine for a strictly passive portfolio, but as soon as it’s active—as smart beta is—a lot of those index characteristics can actually hurt you,” he says.
“In the case of low volatility, there’s a very good reason we don’t pursue the basic minimum variance approach,” says McCarthy. There are a number of minimum variance strategies that seek to build the lowest beta portfolio possible, which gives rise to a beta exposure that moves around through time and can contain unintended risk, such as regional, sector and security concentration risks, for example. “Very importantly, it misses the point that the low volatility anomaly itself is actually more of a high volatility phenomenon,” he says. Avoiding the highest volatility stocks is just as important, if not more so, than selecting those with the lowest volatility. “Rather than building a portfolio that seeks the lowest beta stocks regardless of fundamental attractiveness and taking on unwarranted sector, liquidity and crowding risks, we target a constant portfolio beta of 0.75, and use our alpha models to find the most attractive stocks within a broad low volatility stock universe. This allows us to build low volatility portfolios with attractive fundamentals that have produced very sound risk-adjusted returns,” he says.
“There’s considerable subjectivity embedded in the methods used by smart beta developers, so this is not a passive exercise” says McCarthy. There are a lot of decisions being made on the front end in terms of factor definition, portfolio construction and rules around rebalancing. “All these things require practitioner judgments at the outset, and the choices, and ultimate returns, will therefore vary greatly by provider,” he says. “We have many discussions with clients about creating custom blends of factors. For clients seeking particular factor exposures, we are able to customize portfolios to include those exposures with an awareness of the markets in which they are expressed,” says Berger. “There is a lot of potential there.”
“These ideas are intuitive, they are well understood by definition and they are simple in most respects, but the craftsmanship is where you can really differentiate a good long-term source of return or not,” says Israel. “We spend a tremendous amount of time focusing on implementation—how do we take these ideas and translate them into the most effective portfolios possible.” That starts with defining exactly what will be captured with a focus on diversifying multiple styles and multiple asset classes, when possible, versus just one, then integrating those elements into one portfolio. “We take these ideas and try to diversify them with each other and across different dimensions in portfolio construction, because we believe this leads to more effective versions of factor and style premia strategies,” he says. Risk management is a large element as well, especially in the long/short versions of these strategies. “You might need what we jokingly refer to as LSD—leverage, shorting and derivatives,” he says. “There may be a need to use them as tools to accomplish a strategy’s objectives, and they’re effective tools, but ones that need to be carefully managed.” There is also a focus on trading, particularly in ways that lowers the cost of implementation and that extracts as much of the return as possible. “In many ways, this is what separates something that looks good on paper versus something that looks good in an investor’s portfolio,” he says.
Strategies for Current Markets
“Since early December, we’ve seen a flight from momentum and a real factor rotation,” says Draper. For example, the spread between momentum and value was at its widest going into the fourth quarter of 2015. “That was largely encouraged by loose monetary policy in most of the developed world,” he says. Also, the technology, biotech, healthcare and other high-growth sectors, represented by momentum, have had a great multi-year run. “We’ve seen large flows rotate from various momentum strategies, mostly moving into low volatility and quality,” he says. “We have yet to see a movement into value, and we’re expecting to see renewed interest at some point.” Investors are still looking closely at balance-sheet and earnings quality, even though valuations look good on a relative return basis. “Until we see that movement into value, it does seem that low volatility and quality are the points of destination right now,” he says.
“In what many believe will be a low return world going forward, many investors are focused on absolute return strategies that can deploy alternative risk premia along with sources of alpha,” says McCarthy. Many asset owners with exposures to hedge funds are looking for substitutes—or, more often, complements—to those they already use, with a different degree of liquidity, transparency, and fee structure, especially if they’re looking to scale up the programs. “Having strategies that use alternative beta as the core and have similar diversification and risk-return profiles as hedge funds is attractive to those wanting to do more on the alternative side but wrestling with some of the challenges. Our ALTA strategy, for example, addresses this very need,” says Berger.
Traditional bond indices are often weighted by the size of debt issuance, with the most indebted countries representing the largest index exposures. An example is Japan, which represents 28 percent of the World Government Bond Index and is paying zero to negative yields on the 10-year. “In that context, is a 28 percent allocation ideal?” asks McCarthy.
Wellington Management’s Global Strategic Sovereign strategy combines a subset of healthy sovereign exposures that are risk weighted to target a better risk-return profile. First, by independently evaluating key factors like the credit profile and potential change for each sovereign, relative valuation, and liquidity, a subset of eight to 15 countries emerges. “We then combine this perspective in a more risk-weighted construction, providing what we view as a better market exposure” says McCarthy. “We’re not just simplistically saying, ‘Okay, here’s the sovereign universe, we’re going to cast the weightings of the various constituents in a way that is more risk weighted,’ which is one approach you could take.”
“There’s value in using risk weight, but the challenge is to get a risk estimate for these countries,” says Berger. One way is to assess the volatility of the markets historically, but that approach may miss forward-looking risks or opportunities in a particular country’s debt that’s not reflected in its recent performance. Without that oversight, it’s like the computer programming notion of “garbage in-garbage out”. “If you’re starting with data that’s missing some fundamental risk, you’re going to end up with a very skewed portfolio,” Berger says. “So that’s where our insight comes in—we’re not simply risk-weighting everything, we’re evaluating the countries according to what we think is an accurate measure of the risk and building a portfolio from there.”
In October 2015, PowerShares launched five Tactical Sector Rotation Portfolio ETFs, based on Dorsey, Wright & Associates’ indexing methodology for sector selection and weighting. “The innovation was to offer dynamic asset allocation within an ETF, and we also added a cash component that enables higher volatility sector weights to move to cash if necessary for better downside risk management,” says Draper. “Not only are you getting those different sectors which have momentum, but you’re also receiving a risk premium through the rebalance.” This is done through DWA’s methodology, in a tax-efficient ETF wrapper.
“We would make an unconditional, long-term argument that these things should be part of an investor’s portfolio,” says Israel. One could also make a conditional argument that the need for diversifying sources of return may be even more important in a world with lower prospective returns in traditional asset classes and where increased volatility is likely. “The need for strategies that diversify away from traditional asset class exposure may be even more important, and people are responding to that,” he says. “They are looking at their portfolios and thinking about reducing some of that traditional asset class exposure by putting on uncorrelated sources of returns—ones they think are intuitive, have long-term persistence and can be captured at a fair fee.”
“Each time we apply the idea of style premia in various markets, we find that the investment thesis holds up, which is a nice out-of-sample test, and it gives us more confidence that these are truly persistent sources of return,” says Israel.