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Addressing Unmet Needs of Asset Owners—Integration of smart beta in portfolios to help control exposures

Part of Institutional Investor's Report on Smart Beta

By Scott Bennett, Director, Equity Strategy & Research, Russell Investments

In January 2014, Russell Indexes conducted a survey of equity investment decision makers from almost 200 asset owners across North America, Europe and the Middle East to better understand perceptions of smart beta. In the survey we found that the greatest unmet need from asset owners was for the ability to use smart beta indexes to control their exposures.

Smart beta happens to be a narrow term that is often used to define a broad range of strategies. At Russell, we generally break them down into two types. The first type is “strategy-based” and the second is “factor-based”. Strategy-based smart beta exposures have seen a lot of popularity over the past few years and are typically non-cap weighted, with an emphasis on the strategy’s potential ability to outperform a traditional cap-weighted benchmark. Factor-based smart betas on the other hand are designed to provide exposure to a segment of the market that displays similar factor characteristics (i.e. value, momentum), and asset owners that are looking to manage exposures typically look to factor-based solutions.

The factors we are focused on at Russell, which are also the primary drivers of active equity returns, include: value, momentum, quality and low volatility. We believe that smart beta exposures, whether they are strategy or factor-based, can serve as a strong complement to an active portfolio with the potential to enhance returns, help reduce portfolio risk and add diversification. The three key parts of our process where smart beta exposures are employed are:

Strategic

From a strategic point of view, we utilize smart beta strategies to position our portfolios in line with our long-term investment beliefs. For example, Russell believes there is a value premium in the market and when we construct our portfolios we want them to be biased towards value. We also believe that medium term momentum works well and that our portfolios should also have that same exposure.

Dynamic

The next approach is considering smart beta strategies from a more dynamic or tactical basis. Within our own portfolio construct we are increasingly more adaptive in how we position the portfolio through different market cycles. Although we have longer term beliefs regarding the expected pay-off to different factor exposures, we recognize that over shorter term horizons the interplay of the market cycle, valuations and sentiment can present opportunities to take advantage of market dislocations. We believe having smart beta exposures that allow us to adjust the portfolio to the changing market conditions, enables us to get the right exposure at the right time.

Risk Management

A third approach is to integrate active and passive allocations within the portfolio structure. For example, we believe the portfolio could incorporate an exposure to smart beta strategies designed to complement the stance taken by the active managers as a whole. Russell research has shown that in general, active managers are overexposed to more volatile stocks, and what may appear to be a well diversified portfolio is actually overexposed to the volatility factor. Shifting a portion of the equity allocation to a defensive strategy can continue to provide the active management opportunities while potentially mitigating the unwanted exposure to volatility that may be introduced by active managers.

The ability to effectively combine factors within a portfolio has historically been limited to quantitative based asset management firms. In response to the desire and need to control portfolio exposures we launched the Russell High Efficiency™ Factor Index (HEFI) series. The series brings many quantitative techniques and insights to investors in a modular framework that is designed to be easy to implement and manage. The consistent methodology utilized across the HEFI series also offers a unique advantage to investors who are looking to control and manage exposures and effectively combine their smart beta allocations with traditional active strategies.

For more information about Russell Indexes, visit
www.smartbetaindexes.com

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