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Using Smart Beta to Outsmart the Market

Part of Institutional Investor's Report on Smart Beta

To capture yield and mitigate risk, investors have embraced smart beta strategies. Rules-based and transparent, they reweight traditional cap-weighted indexes by a variety of specific factor exposures.

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A number of smart beta providers describe the growing awareness, adoption and implementation with a look forward to sophisticated applications that are changing how risk is measured and returns are achieved.

While the concept of smart beta reaches back decades, its relatively recent rise and accelerated adoption is rooted in the aftermath of the financial crisis six years ago. In a prolonged near zero interest rate environment, investors are still in a predicament. Bond yields are tepid, and yield-seekers are moving steadily toward riskier credits. The robust equities market has ramped up disproportionately to economic growth.

Pension funds, endowments, insurance companies and other institutions are seeking new ways to drive returns, but, still smarting, they want them on a risk-adjusted basis. “We’re in a world of scarcity of returns, and it’s difficult to beat the benchmark by sector and country allocations alone,” says Francois Millet, ETF and indexing product line manager at Lyxor Asset Management. “Smart beta strategies are based on rewarded risk factors and provide higher and more stable returns.” Smart beta has stepped into the spotlight.

Traditionally, institutions have engaged active managers to achieve alpha, the selection of assets, strategies, and tactics that will outperform a market benchmark. Beta is the return achieved from the overall market itself. The returns of a broad index fund, such as an exchange-traded fund (ETF) based on the S&P 500, is a good example, and investors often use such passive investments as a core element to maintain market exposure. The key here is that the components of a traditional index are selected in proportion to their market value, or market capitalization, which puts more emphasis on the largest companies. Investors have found that this does not drive returns and can introduce unwanted risks.

Smart beta is something of a hybrid. Based on academic theory and rigorous analysis, the idea is to gain greater exposure to specific investment factors in a transparent, rules-based approach. It keeps the passive, simple strategy of index investing, but it endeavors to enhance returns by deviating from the traditional weighting of assets by market cap. Instead, securities are weighted by relative price/earnings value, relative volatility, momentum, quality, and other risk-based or market segment criteria.
This can achieve risk reduction in a portfolio and enhance overall returns.

“In 2008, many institutional investors were disappointed with their active managers’ response to the financial crisis, and losses were often greater than common benchmarks,” says Lynn Blake, CIO, global equity beta solutions at State Street Global Advisors (SSgA). Many ultimately decided that active managers had made negligible contributions to investment performance and increased their allocations to passive strategies. Cost was another factor. Between 2009 and 2013, the portion of assets under active management by UK pension funds fell to 53.6 percent from 66.8 percent, according to the Investment Management Association.


“Increasing allocations to passive strategies, however, is only one part of the solution,” says Blake. Cap-weighting automatically gives the most influence to the largest stocks—which may be overvalued. Concentration risk is a concern as well: those largest stocks may be concentrated in a particular sector or comprised of a small number of very large companies. In fixed income indices, market-weighting can give greater exposure to the most indebted companies or countries.

Smart beta is similar to factor investing, a concept that has been around for some time. But they are two different things. “With a traditional factor-based approach, there is greater exposure to stock-specific risk; you haven’t necessarily diversified away other risks inherent in the traditional factor approach,” says Eric Shirbini, global product specialist at ERI Scientific Beta. The ERI Scientific Beta approach to smart beta, or as they call it ‘smart factor’, will identify all the stocks to include in a particular factor-based index, but use a diversification-based weighting scheme. “That’s what had been missing in the market,” he says. Existing smart beta strategies can achieve specific investment objectives, such as limiting volatility or generating income, by utilizing a fundamental, or factor-driven, weighting methodology but such an approach neglects diversification. “As the basis of an investment approach, there are big gaps in traditional cap-weighted indices,” says Dan Draper, managing director of global ETFs at Invesco PowerShares Capital Management.

“As the concept of alternative beta and systematic exposure to factors develops and broadens, the number of ways to implement it in a portfolio is growing. “It is a spectrum,” says Ronen Israel, principal, AQR Capital Management. At one end, there is long only in a single asset class, usually equities, employing a single style. On the other end, there is long/short, employed in multi-asset class and multi-style portfolios. “You are still in a world of capturing systematic levels of return,” he says, “and the more you move along the spectrum, the more bang for your buck you’re getting in terms of style exposure.”

Active or passive?

There is a lot of discussion about smart beta being an active or a passive strategy, and the truth lies in between. “Smart beta sits between the two,” says ERI Scientific Beta’s Shirbini. It is neither 100 percent active nor 100 passive. “It’s rules-driven, so it’s a passive style, but it does not passively just follow the market but also gives exposure to certain factors,” he adds. An important question arises: As smart beta grows, are investors replacing cap-weighted investments, or are they replacing active management? Investors recognize that cap-weighted investments are too concentrated, and there is concern about being overweight in large-cap growth stocks but even more importantly they are also beginning to realize that smart beta does what active managers do: value tilts, market segment tilts, momentum tilts,” he adds.

Sara Shores, managing director and head of strategic beta at BlackRock, says she had expected new allocations to smart beta strategies to come predominantly from market cap-weighted indexed investments, but that wasn’t necessarily the only case. “It’s also a potential replacement for active management, because of the lower cost, lower governance, and need for less oversight, but we see it funded from both sides,” she says. She observes that the general trend is to streamline the investment lineup by reducing the number of active managers and giving higher allocations to index funds and smart beta. Her colleague Ronald Kahn, managing director and global head of scientific equity research at BlackRock, says, the impact is on active management,” pointing out that strategic beta takes what active management does and puts it into a transparent, low-cost product. “Now active managers can focus on driving alpha,” he says.

“Anecdotally, it’s been a replacement for active management,” says SSgA’s Blake, and 64 percent of respondents to SSgA’s survey say that smart beta is a viable alternative to active management. The answer is both. Respondents to Russell Indexes’ survey are divided equally when asked if smart beta should be part of an active or passive equity allocation. “We see allocations to long-only ‘smart beta’ strategies coming from active long-only managers,” says AQR’s Israel, while those for long/short strategies often come from alternative and hedge fund allocations. Investors are recognizing that a lot of what they’re getting currently is exposure to these classic sources of return but on worse terms and in a less efficient way, he notes.

Many investors with a core-satellite approach often use market cap-weighted indexes as the core and utilize a number of active managers to pursue satellite strategies. “In this strategy, we’ve found that the risk exposures from active managers tend to cancel each other out,” says Matt Peron, global head of equities, Northern Trust., noting that there usually unintended exposures that need to be mitigated in the indexes as well.

“An investor might hold a combination of actively managed strategies, cap-weighted indexed strategies and smart beta strategies within a diversified global multi-asset portfolio,” says Rolf Agather, managing director of global research and innovation at Russell Investments. Determining which strategies are preferable will depend on the investor’s individual beliefs, objectives, tolerance for risk and time horizon. Integrating smart beta strategies within a broader portfolio requires a high degree of assessment and ongoing analysis and review, similar to those of any active strategy. “For example, smart beta strategies that target the same factor, such as low volatility, can differ in their construction, and can have significant differences in market exposures and performance,” he says. Investors need to have a thorough understanding of the objectives and the construction methodology of a smart beta index, and how the index can be expected to perform in a range of market cycles.

Adding Outperformance

The process of integrating a smart beta strategy into a portfolio is considered active, like any investment decision. “It requires extensive due diligence, which can be similar to the process used when selecting an active manager,” says SSgA’s Blake. Perhaps most importantly, advanced beta involves the transfer of risk to the in-house team, which must hold responsibility for the investment performance and therefore be judged in the same way as an active manager, she explains. However, being systematic, transparent, and rules based, its execution is passive in nature, and once implemented, there isn’t generally a great need for active intervention.

“While there are active managers who outperform the market with pure alpha on a factor-adjusted basis, there are many others whose outperformance relative to the market (traditional alpha) which can largely be explained by exposures to one or more common factors,” says Kal Ghayur, head of ActiveBeta equity strategies at Goldman Sachs Asset Management (GSAM). Smart beta strategies, which seek to deliver an efficient capture of common factors, can thus be viewed as a passive alternative to factor-based active management. Additionally, for investors with predominantly index exposure on a market-cap basis, smart beta strategies can potentially add sources of outperformance, while typically providing more transparency, simplicity, and lower fees, compared to active management, he says.

“It’s the third pillar, in addition to active and passive, of a dynamic institutional portfolio,” says Lyxor’s Millet. Smart beta is intended to be integrated into the core portfolio of institutional investors, weighing generally between 10 and 40 percent of their passive management. “In some European pension funds, sometimes smart beta indices exceed 40 percent of their core portfolio,” he explains. More traditional investors allocate it to their active asset management.

Because of decisive factor tilts and purposeful integration into portfolios, US investors typically see smart beta as more of an active strategy competing with other active managers, explains Shirbini at ERI Scientifc Beta. European investors use it as more of a rules-based and semi-passive approach to achieving relative returns at a lower cost. In this context, there are two applications. “If an active manager is not performing, an asset owner can often replicate the strategy more efficiently and at a lower cost,” he says. In addition, when looking at overall exposures and evaluating risk, an asset owner can add a factor to balance and mitigate if there is too much in one particular area. “For example, if you’re overweight in value, you can add a growth smart beta strategy as part of the asset allocation decision,” he says.


Smart beta should be set up to give exposures you want to achieve your goals. “It works best when changing the question from ‘How do I beat the benchmark’ to ‘How do I meet my goals,’” says Peron at Northern Trust. “How do you know if your benchmarks are even the right ones to reach your goals,” he asks, adding that investors need to get out of the style box.

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The probability of success depends on the thoughtful exposure to factors. “The market is grappling with the question of integrating active management, traditional indexes, and engineered strategies, but each can complement the other,” says Peron. Again, it depends on the investment goals. Low-cost indexing can provide broad market exposure, and engineered strategies with a value tilt can drive returns and mitigate risk, but a sizeable allocation is required to move the needle. The recommended allocation depends on investment goals, philosophy, measurement, and many other factors, but it’s generally in the 20-30 percent range or more, he says. “One or two active managers, chosen with high conviction, can be used to capture the premiums associated with alpha strategies,” he adds. “It’s out there!”

Smart beta strategies offer two levels of diversification within a broader portfolio structure, which directly impact the overall risk-return profile. First, individual factor portfolios have unique risk-return characteristics, which result in low or negative pair-wise correlations. “As such, factor diversification strategies are designed to provide an opportunity to realize significant risk reduction as well as return enhancement benefits, and facilitate certain investment objectives,” explains GSAM’s Ghayur.

Second, investors that explicitly allocate to smart beta strategies to capture factor returns, and separately allocate to active managers with demonstrated uncorrelated excess returns, have added an additional layer of diversification, he says.

“While traditional quantitative equity alpha strategies share much in common with smart beta strategies, there are important differences in their approach to investing, the characteristics of resulting portfolios, and the flexibility that is afforded to investors,” says Ghayur. Ultimately investors will need to decide whether they believe in the ability of common, well-understood and rewarded factors to provide long-term outperformance, or whether a quantitative approach utilizing the proprietary skills and capabilities of an experienced investment manager may provide an edge. “We believe that these strategies can also be used together for those investors who want to combine the benefits of common factor investing with the insight of a skilled quantitative equity alpha manager,” he says.


“The top two uses of smart beta are risk reduction and return enhancement.” Says Russell’s Agather. After the financial crisis, many pension plans were severely underfunded. To improve funding ratios, they needed to maintain significant allocation to equities, he explains, and defensive/low volatility strategies enabled them to benefit from exposure to the growth in equities while reducing volatility. “There is an inverse relationship: lower risk has meant higher returns in a down market,” he says, and allocations to low volatility index funds lowered the overall volatility of a fund. Today, with equities at record highs and most pension plans at 100 percent funded levels, the same strategy is used for derisking.

Over the past three years, more investors have embraced a strategic combination of factors. “The greatest demand is the multi-beta-approach,” says ERI Scientific Beta’s Shirbini, pointing out that combining them gives smoother performance over time. Factor returns are quite cyclical, but the timing of cycles can vary, so the idea is to invest in a range of indices that aren’t correlated. “Smart factor investing isn’t a short-term strategy even when investing in multiple factors,” he says. “You have to think over the long term, and at least through one complete cycle but by investing in multiple factors relative drawdowns are reduced.” Many investors combine low volatility, which performs well in a falling market, with value, which performs better in a rising market. “In our current bull market, low volatility has become slightly less popular now, so some investors are combining value with momentum,” he says, “but the key to smart beta investing is to think of the investment over the long term.”

Many investors start with a single factor to achieve a specific goal and progress into a multifactor strategy. “When you utilize a factor in isolation, the risk-return profile can be compelling in the long term, but there can be periods of significant underperformance,” explains SSgA’s Blake. “There are times when factors move differently, so the idea is to combine them.” The benefits are good diversification but not at the expense of high returns, and the element of timing is taken out. The trick is how to combine, and significant research and evaluation is needed to determine which factors to include.

Identifying Objectives

Implementing smart beta is about problem solving and addressing specific investment issues strategically. “Investors want to capture smart beta in relation to their risk budgets,” says GSAM’s Ghayur. “The idea is to provide a framework for investing in smart beta, within the context of an overall portfolio. It’s not a specific product -push solution.”

Low volatility and fundamental indexes dominate the smart beta strategies being evaluated and used by asset owners, according to Russell Indexes’ survey. However, there are regional differences. Fundamental index usage is much greater in the US and UK, while low volatility is the dominant strategy in continental Europe and Canada.

Low volatility funds have indeed experienced the greatest growth, practically doubling in 2013, according to Cogent Research/Invesco PowerShares. Two-thirds of respondents not currently using smart beta ETFs say they are likely to use low volatility funds in the next three years. The need to manage volatility has become more important in recent years and is driving this trend. “Investors need income, but interest rates are near zero, so many are allocating to low-volatility ETFs,” says PowerShares’ Draper. “No one wants to live through another financial meltdown unprepared.” Inflows into high dividend fundamentally weighted and share-buyback ETFs are also expected to grow significantly as well.

“One trend we’re seeing is the tendency of investors to avoid a single risk by combining fundamental indexes with risk factors, and combining risks that counteract,” says Lyxor’s Millet. In the bull market leading up to 2008, quality tended to underperform versus the broad market, while value tended to outperformed. After 2008, it was the opposite. “No one knows how to allocate among risk factors. Many investors in European markets are building equal-risk weighted portfolios by size, value and low volatility, but that’s not enough,” he says, noting the need to construct portfolios by risk factors. It’s always a bespoke solution, based on strategy dialogues with each client. “These are the building blocks of smart beta,” he says.

Depending on the investment objective, there could be a number of combinations and strategies. For example, an asset owner may wish to lower the total volatility and potential drawdown of an equity portfolio. “A low-volatility plus quality diversification strategy may help achieve that objective,” says GSAM’s Ghayur. Similarly, a value plus low-volatility diversification strategy’s objectives are return enhancement as well as risk reduction, and is designed to help improve risk-adjusted returns. Another investment objective might be to outperform the policy benchmark, while managing the risk and magnitude of potential underperformance. A momentum plus value diversification strategy might help achieve this objective, he explains.

“In the early days of 2010-2011, the question was how to apply this way of thinking,” says Shores at BlackRock. Institutions tend to be quite siloed with separate groups devoted to equities, fixed income, alternatives, and others. “It’s often hard for them to be holistic,” she says. But factor investing is becoming more of an accepted concept. Now the larger investors are beginning to think in terms of risk premia and the idea that there may be better ways to allocate among them. “Three or four years ago, we heard ‘I want one factor,’ like low volatility or equal weight,” she says. Now it’s about allocation to combinations of risk factors. “It’s powerful to create a custom portfolio that allocates among them, and it highlights the best attributes of strategic beta,” she adds. Kahn adds, “A custom strategic beta strategy coupled with index and active strategies will together likely deliver a more consistent performance than just index and active strategies by themselves.”

Looking broadly, it’s best to integrate as many factors as possible. “You want to capture as many proven and diversifying styles as you can and have them work together, not in siloes, but interactively,” says AQR’s Israel. The issue is how the various portfolios net out. “Say there’s a stock that may not quite meet the criteria for the value portfolio and also may not quite meet the criteria for the momentum portfolio,” he says. “That’s potentially the cheap, outperforming stock that you might want to own the most.” The idea is to put together a rules-based portfolio that takes into account the interaction of styles, which can also save on trading costs and taxes for a taxable investor. “It’s about craftsmanship—a thoughtful selection of those elements that work best in combination,” he says.

Beyond Equities

While smart beta is usually discussed in the context of equities, it has equal applications in fixed income and other asset classes. Among respondents to SSgA’s survey, 56 percent express an interest in smart beta fixed income strategies. It works in much the same way: a traditional market-value fixed income index exposes investors to the most indebted issuers, whether they are corporations, governments, or other entities. Concentration risk is an issue here as well, and significant losses can be triggered through defaults. A smart beta strategy can weight credits by fundamental factors, such as GDP growth for sovereign debt by underweighting countries with low growth and overweighting those with high growth, for example. Additional factors can be built in as well, such as underlying volatility or pricing volatility.

The idea is to achieve a more balanced allocation of risk within fixed income. “We ask, ‘What are the risk factors that are driving returns?’ and we treat rate risk and credit risk in a more balanced fashion,” says BlackRock’s Shores. It’s the same process of asset allocation, but through a risk-factor lens. Other fixed income strategies customize a parent index or portfolio of assets to reduce downside credit risk. It might underweight or eliminate downgraded securities or those with the highest risk of default, reinvesting those proceeds in a thoughtful and risk-controlled manner to retain the same broad risk and return characteristics of the benchmark. The expectation is that the strategy will outperform in down markets.

There are other techniques as well. If issuers are sorted into deciles by their respective spreads, the best risk-adjusted returns are to be found in the middle. “The safest, with the lowest spreads, don’t provide sufficient return, and the riskiest, with the highest, are simply too risky,” explains Helmut Paulus, CEO, CIO, and managing partner at Quoniam Asset Management. “We like the sweet spot in the middle.” And counterintuitively, he explains that duration risk goes unrewarded. “It’s the short-duration maturities that provide the greatest level of return per unit of risk,” he says. Sorting issuers by their sensitivity to interest rates shows that longer-dated bonds are more volatile for less return than short-term paper. Sorting by duration and diversifying by sector and issuer creditworthiness can increase the Sharpe ratio by more than 30 percent, but it takes rigorous quantitative research and data evaluation, issuer selection, and regular rebalancing to keep on top of the risk and return dynamics in the market.

The development of multi-asset strategies that predominantly use passive implemented exposures reflect broad factor asset allocation views is another dimension in the broadening beta toolkit. “This requires effective diversification across asset classes that achieves the best results for a strategic portfolio. One version focuses on rewarded risk factors, the drivers of return that underlie each asset class,” says BlackRock’s Kahn. Risk factor-based allocation strategies aim to deliver attractive risk-adjusted returns by focusing on the drivers of return, as opposed to asset class views, to achieve more efficient diversification.

Examples of risk factors include macro factors like interest rates, inflation, credit, political, liquidity and economic risk, in addition to style factors including value, momentum, quality and volatility. For example, an investor holding high-yield debt will expect to be compensated for all the risks to which they are exposed to such as interest rates, inflation, credit and liquidity risk, over the long term. To create a portfolio diversified by risk factors, the manager identifies which combination of asset classes gives the best exposure to each. Passive holdings are then combined to provide better balanced exposure allowing for capital growth with limited volatility. “This could change the landscape of investing,” says BlackRock’s Shores.

While typically smart beta has come in the form of single-style, long-only equity strategies, more investors are applying the rules-based concept to multi-style, long/short, multi-asset portfolios. The same concept applies when you broaden it. “You don’t have to focus on just one asset class,” says AQR’s Israel. An investor can implement a long/short strategy across multiple asset classes and styles in a way that’s diversified and uncorrelated to what an investor may already hold. “More investors are migrating in this direction,” he says. n

Is it Smart, Strategic or Advanced?

Smart beta has become the term accepted by the marketplace for indexes that are not cap weighted, or more specifically, for alternative ways to gain exposure to the market based on risk factors or market segmentation techniques. However, the tag remains a controversial choice. “We don’t believe there’s an industry standard,” says Sara Shores at BlackRock. “The term ‘strategic beta’ better describes the products and strategies we’ve developed that seek to deliver exposure to the factors that are long-term drivers of asset class returns.”

Other terms include advanced beta, engineered equity, factor indexes, alternatively weighted indexes, and many others. “Smart beta is an unfortunate and provocative term,” says Lynn Blake at SSgA. “We call it advanced beta, or alternative beta, which are true to what these strategies represent.” She explains that it implies that anything other than a non-cap weighted approach isn’t smart. “The term smart beta suggests that a cap-weighted portfolio is not relevant, and it very much is,” says Lyxor’s Francois Millet. Cap-weighted beta forms the basis of most benchmarks, it remains central to many investing strategies, and is the only portfolio that everyone can hold. “We prefer the term ‘engineered equity,’” says Matt Peron at Northern Trust. It captures what we’re trying to do with compensated risk factors—engineer them in or engineer them out.” n

US vs Europe

Thanks to their low cost, flexibility, transparency and ease of implementation, smart beta ETFs have experienced tremendous growth over the past year. They are now being used by 1 in 4 institutional decision makers, according to Cogent Research in a survey done for Invesco PowerShares. Additionally, over one quarter of the US ETF equity net flows in 2013 went into smart beta ETFs even though this category represents just 19 percent of assets in the ETF industry.

According to several surveys, most institutional investors have a high level of awareness of smart beta. More than two-thirds say their awareness of advanced beta as a concept is excellent or good, while a similar portion say the same about their understanding of different advanced beta strategies. Investors in Europe, where advanced beta strategies are better established, are more familiar with the concept: 70 percent describe their awareness of advanced beta as excellent or good, compared with 57 percent in the US, according to SSgA’s “Beyond Active and Passive: Advanced Beta Comes of Age.” Knowledge about advanced beta also varies between different investor types. Public and private pension funds report high levels of awareness about advanced beta as an investment concept, while endowments and foundations say they are less familiar.

Smart beta adoption is happening and happening broadly. Thirty-two percent of asset owners surveyed currently have smart beta allocations, according to Russell Indexes’ “Smart Beta: A Deeper Look at Asset Owner Perceptions.” Adoption is highest among the largest asset owners, those with more than $10 billion in assets under management (AUM), with 46 percent already having smart beta allocations. Plus, they are more likely have evaluated smart beta or plan to do so in the next 18 months. Among those with AUM of $1 billion to $10 billion, 77 percent respond similarly, along with half of those managing less than $1 billion.

The primary reason that institutional professionals use smart beta ETFs stems from their belief that these funds generally outperform the market say 31 percent of respondents, according to Cogent Research/Invesco PowerShares. In addition, these ETFs provide investment professionals a more efficient means for diversifying their portfolios and reducing overall portfolio volatility. Those who haven’t yet incorporated smart beta ETFs into their strategies cite a general lack of familiarity. Curently 34 percent of institutional decision makers surveyed are unfamiliar. Others respondents cite the lack of a track record (12 percent) and a preference for active management (9 percent).

European institutional investors are outpacing their North American counterparts in awareness and adoption of advanced beta strategies. In Europe, 40 percent of asset owners have adopted smart beta; in North America, 24%, according to Russell Indexes. Only 15 percent of European investors do not expect to evaluate smart beta in the next 18 months compared to a full 34 percent of North American investors. Furthermore, More than 7 out of 10 European respondents have a strong awareness of advanced beta as an investment concept, compared with 57% from North America, according to SSgA. Almost one-quarter of European respondents have allocated 20 percent or more of equities in their portfolio to advanced beta, compared with just 4 percent of those from North America, and European investors are more likely than those from North America to have applied low-volatility, low-valuation, momentum and equal-weighting strategies. Russell Indexes reports that European asset owners more often view smart beta indexes as possible benchmarks, while North American asset owners tend to see smart beta as a tool to control unwanted exposures or to introduce wanted exposures in a portfolio.

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