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Smart beta strategies continue to grow as a growing 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.
Smart beta strategies fall into three main categories. The first is risk-based indexation and the second is fundamental indexation. “Investors know how these two will behave in particular markets,” says Guillaume Lasserre, head of active investment strategies at Lyxor Asset Management. “When you buy a risk-based strategy, such as minimum volatility or risk parity, for example, you know it will be more resilient than a market cap weighted strategy and you will be well equipped in the kind of market we are facing now.” A lot of clients are using these types of strategies to lower the volatility of their equity investments. Fundamental indexation is similar. “Investors know what they are buying, and the current market is not the most favorable one for fundamental strategies,” he says. The third category is risk factors which are tactical tools that can benefit from different market conditions. “Currently, the small-cap and value risk factors are underperforming the market-cap index, while the low volatility and quality factors are outperforming,” he says. “What is important in the smart beta offering is to understand the kind of smart beta behavior you have bought.”
“Maturity around the smart beta approach has risen lately, especially over the past year,” says Matthieu Guignard, global head of product development and capital markets at Amundi ETF, Indexing & Smart Beta. Many clients who had implemented smart beta in their portfolios had used only single factor strategies, such as low volatility, which is by far the most popular strategy in the smart beta world. “Clients are beginning to realize that low volatility or another single factor can work well in some market situations, but not in others, so now they are more interested in implementing multiple strategies that include several factors at the same time,” 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.
Factor Focus
Many investors look to smart beta to offer a lower risk profile to their portfolio with an enhanced return, especially in the current market environment. “If there were one factor that could be useful in this environment, it could be low volatility,” says Guignard. A low volatility strategy can enable exposure to equity markets with protection on the downside. “It really makes sense if you look at what happened last year and what has happened at the beginning of this year,” he says. Multi-factor solutions can be helpful in improving performance and reducing volatility as well. For example Amundi’s Global Equity Multi Smart Allocation Scientific Beta ETF outperformed the MSCI World Index by about 2.5 percent, and volatility was reduced by more than 1 percent. “So you really improve the risk-return profile of the portfolio,” he says.
“Some investors are quite technical and sophisticated, and they want to make their own allocations to factors,” says Guignard. They want to choose which factor to invest in, and how they want to weight each factor in their portfolios. Others prefer to leave it to the investment manager—or to track a multi factor index. When this is embedded into an index, the weighting approach we take is very simple: It combines low volatility, momentum, size and value, with five smart beta diversification strategies, weighted through equal risk contribution. “This means evaluating the risk embedded within each strategy, which we measure by the tracking error brought by each factor, and each factor contributes equally in the overall tracking error of the index,” he 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 that 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.
Index and Portfolio Construction
Any portfolio manager would acknowledge that timing factors in the short run is nearly impossible, just like 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.”
“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, health care 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.
Innovations
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.
“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 one 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.”
Smart beta is being applied to ESG (environmental, social and governance) investing as well. “There’s been interest in low carbon strategies, and we’ve been developing two open-ended index funds and an ETF based on MSCI’s Low Carbon Leaders indices, which are weighted based on the carbon scores of each underlying stock,” says Guignard. The results have been compelling, with carbon intensity reduced by at least 50 percent versus the MSCI World and MSCI Europe, the parent cap-weighted indices, and a better risk-return profile for investors also. These long-term ideas can be applied in many different ways.
“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. These long-term ideas can be applied in many different ways.