The New Rules for Capturing Risk Premia
For sophisticated investors, advanced beta offers a new answer to an old question: What is the optimal way to take and be compensated for risk? Lying somewhere between active and index investing, advanced beta represents a new sweet spot for generating risk-adjusted returns.
While active and traditional index strategies continue to have distinct roles to play in portfolio construction, we believe advanced beta strategies are changing the game in terms of how investors identify and take risks in their portfolios.
Simply defined, advanced beta is a rules-based approach to investing that seeks to capture specific risk premia in the marketplace, such as those historically associated with value, low volatility and small-cap stocks, or the issuer and credit risk of corporate or sovereign bonds. Advanced beta strategies combine the transparency, liquidity and flexibility of indexing with the ability to take an active view on which risk factors may outperform over time.
As a result, advanced beta portfolios are able to capture specific risk/return characteristics in a more cost-efficient package than active management. With the potential for generating attractive long-term risk-adjusted performance, advanced beta strategies may serve as an effective complement to both traditional active and index holdings. Whether investors are rebalancing away from active or index strategies, advanced beta offers the potential for improving Sharpe ratios without overpaying for performance.
From Theory to Practice
Starting in the 1970s, many researchers began to find that some of what people thought of as an active managers outperformance due to superior asset selection could actually be chalked up to distinct, identifiable market factors.1 Often more important than the performance of an individual stock, for example, was whether it belong to the value, low volatility or momentum category. Selection alone, the data seemed to suggest, may not fully explain their performance.2 Part of the returns an active manager delivers may be derived from general risk premia that exist in the marketplace.
Still, it took the financial crisis of 2008 for the day-to-day investment community to start taking up these ideas.
In the aftermath of the crisis, we have seen many investors re-examining the question of how to access the risk premia they seek. A big part of the appeal of indexing had always been the diversification it provides through holding a large number of securities. Yet, during the low point in the crisis when the broader market was down by nearly 50%, even index strategies could only offer so much protection.
At the other end of the spectrum, it was thought by many that the selective use of active management provided lower tail risk in addition to the potential for excess return over the market. The crisis highlighted the limitations of this view.
Against this backdrop, advanced beta has emerged as a way to potentially solve for the sometimes-competing objectives of the post-crisis environment. To the extent that such factors are attributable to systemic risk premiabeta, in a wordinvestors can capture them with simple, transparent, rules-based beta strategies and cut out the middleman.
Factoring in Specific Objectives
Still, advanced beta is not a magic bullet. Its a tool in the hands of the investor. When considering an equity investment, for instance, looking at some common equity factors can provide a logical jumping-off point.
Factors to consider may include:
Low-valuation stocks have outperformed high-valuation stocks over time.
Low-volatility stocks have delivered better risk-adjusted performance than high-volatility stocks over time.
Small-cap stocks have tended to outperform their large-cap peers over time.
Momentum stocks associated with higher momentum have outperformed stocks with lower momentum over time.
Quality stocks of higher-quality companies have delivered better risk-adjusted performance than stocks of lower-quality companies over time.
Investors can choose to access one factor or combine multiple risk factors within a single portfolio.
One popular combination is value, quality and low volatility. This combination theoretically creates a portfolio with lower than average valuation and volatility, and higher than average quality (measured by metrics like profitability, earnings variability and leverage). A three-factor portfolio helps to neutralize cyclical variations.
Once investors have identified the factor or factors they may be most interested in capturing, they can begin to look at the specific realities of their current holdings to consider where and how advanced beta strategies may fit in. If investors need to lower the volatility of their funded status, they would likely seek out advanced beta strategies with a distinctly different (and lower-volatility) cast than the traditional beta holdings being swapped out. Or if they have determined that they are overpaying for some of their performance, they may be looking to mimic existing active strategies, but at a better price.
Putting Investors in the Drivers Seat
Advanced beta strategies allow investors to take true ownership and control of their investment decisions. Rather than relying on asset selection for performance, though, advanced beta seeks to capture risk premia through a rules-based approach. Investors are actively identifying the risk premia they want, while enjoying an index-like implementation of the strategy. The result is the potential for active-like returns, in a rules-based, lower-cost vehicle.
When investing in a single-factor strategy, investors may naturally want to consider making an initial investment when prices are low among securities representing that particular risk factor. When investing in a multi-factor strategy, timing and pricing may still be a consideration, but it may be easier to implement the strategy at a broader range of points in the market cycle. Working with an experienced advanced beta manager can help investors better understand and forecast market conditions impacting the factors they ultimately choose to pursue.
A Leader in Beta and Advanced Beta Strategies
With advanced beta strategies establishing a firmer foothold in institutional portfolios, investors have more ability than ever to choose the exact risk exposures they want. At State Street Global Advisors, we draw upon decades of hands-on experience managing advanced beta portfolios to help clients make the most of these powerful tools. We are one of the largest providers of index and rules-based strategies in the world, with more than $1 trillion3 in traditional and advanced beta assets under management. Our advanced beta strategies alone represent more than $70 billion of assets, making us a valued partner for institutions pursuing rules-based investment opportunities related to specific investment characteristics.
As pioneers in the field of advanced beta, we continue to be on the front lines of bringing advanced beta solutions to market.
We believe advanced beta is potentially underused by many investorsparticularly among those who have clear beliefs in the benefits of capturing individual or combined risk premia. The new rules of the game provide investors the opportunity to meet investment goals with greater precision while paying less for performance. All they need are the convictions, the right guidance and the willingness to do it.
1 Several factors would eventually be discovered, including: low beta (Black, Jensen, and Scholes, 1972); size (Banz, 1981 and Reinganum, 1981); P/E (Basu, 1977); P/B (Fama / French 1993); quality (Haugen, 1979); and momentum (Jagadeesh, and Titman, 1993).
2 The data was reported by researchers in several different articles, including: The Capital Asset Pricing Model: Some Empirical Tests (Black, Jensen, and Scholes, 1972); The Relationship Between Return and Market Value of Common Stocks (Banz, 1981); A New Empirical Perspective on the CAPM (Reinganum, 1981); Investment Performance of Common Stocks in Relation to Their Price-Earning Ratios (Basu, 1977); Common Risk Factors in the Returns of Stocks and Bonds (Fama / French 1993); Do Common Stock Ratings Predict Risk? (Haugen, 1979); Returns to Buying Winners and Selling Losers (Jagadeesh, and Titman, 1993).
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The Spectrum Of Factor Investing
Investors can gain exposure to risk premia associated with different market factors across a broad spectrum of investment styles. Advanced beta represents an inflection point in the continuumit is the last fully rules-based style of investing before the spectrum begins to tip into active management via active quant strategies. As a result, advanced beta can provide investors with active-like returns, while still maintaining many of the benefits that investors expect from traditional indexing, including low costs, transparency and liquidity.
Even within advanced beta, investors can choose from a range of options for accessing the specific market factors they seek. Depending on their objectives, some investors may choose advanced beta strategies based on a single market factor such as value stocks. Others may choose an advanced beta strategy combining multiple factors such as value, quality and low volatility for a more diversified and potentially less cyclical strategy. At State Street Global Advisors, our solutions group can also help investors deconstruct their entire portfolios through a factor lens. They help investors identify precisely where their factor exposures currently exist. They then help them determine which can be accessed most efficiently via indexing, where a true active approach is required, and where advanced beta is the best solution given investors total return objectives, their preferences for managing risks and expenses, and their views on the market.