Smart beta funds will not work in all market cycles and some 'batting' between the factors is necessary. David Waller finds that minimum volatility's recent track record is a good example.
It seems all the smart money these days is on smart beta. The term has come to the fore recently as the catch-all for a family of alternative investment strategies that go beyond the standard market cap-weighted approach to ranking and selecting stocks. Where market cap-weighted indices look only to replicate equity exposure, smart beta strategies focus on the fundamental and sustainable drivers of that performance – digging down to systematically capture everything from quality to value or volatility. This gives a more rounded picture, and advocates say it helps improve the risk/return ratio of a portfolio.
Smart beta aims to solve two key problems inherent in regular market cap-weighted indices. First, market cap-weighted indices don’t give users exposure to all these other factors. And second, they have the problem of concentration, with a tendency to focus on given stocks and sectors, and so may be unduly affected by what happens to a given company or industry. “The aim is to end up with a well-diversified basket of stocks,” says Felix Goltz, head of applied research at Edhec-Risk Institute (ERI). “And to understand the risk exposure of each.”
All major providers of market cap-weighted indices now provide smart beta measures – even if they call them something else. ERI’s Scientific Beta platform recently launched a series of “Multi-Beta Multi-Strategy” indices, combining different smart beta strategies into a single index. According to ERI, these indices deliver excess annual return in relation to the cap-weighted equivalent of almost 4%, with an average improvement in the Sharpe ratio – the measure of return versus risk – of 113%.
Hence what was once a pioneering or even a controversial field has become the norm. FTSE launched RAFI, its smart beta index series, in 2005.
“At the time there was massive criticism that we were doing active management in the form of an index,” says Sudir Raju, a managing director in ETP relationships at FTSE. “Now alt-weighting is everywhere.”
The thinking behind FTSE’s RAFI series provides an illustration of the rationale behind smart beta in general. Its aim was to create a measure that stripped price out of the equation, thus helping users to avoid overpriced stocks. “If you’re top of the FTSE-100 you’ll have a higher price, and that price will wind up becoming a factor in how you’re weighted,” says Raju. “So if it’s a premium pricing, it makes the weight even higher, while the rating in FTSE RAFI may be lower. In a bull run, market cap-weighted indices over-perform the FTSE RAFI; but in a bear run you get the opposite effect – because RAFI is rated only on fundamentals, not the behaviour of market.”
While the smart beta landscape is vast, and now includes weightings on everything from dividend levels to cash flow, there are a few key measures that tend to dominate: momentum, value, minimum volatility, quality, risk and size. These act as a neutral yard-stick with which to highlight any imbalances in the market cap-weighted indices. A risk-weighted index measures the historical risk of the stock and inverse rates them, so stock that’s twice as risky will have half the weight. A value-weighted index gives greater weight to the cheaper stocks with good fundamentals, while momentum gives an extreme short-term view, which reflects which stocks have been performing strongly in the past, say, 12 months.
As most smart beta strategies are low beta strategies, they will underperform against the market cap-weighted indices if the latter are doing very well. But some argue there’s substantial documentation that over long periods these strategies add value.
“Look back over the last 10-15 years, all the smart beta factors would have beaten the benchmark,” says Vinit Srivastava, from the index research and design team at S&P Dow Jones Indices. “But not all those factors work across all market cycles.” The trick is that each has its times where it doesn’t work too, because each has its imperfections as well as its strengths.
Minimum volatility provides the perfect example of this. The factor, which gives the strongest weighting to the least volatile stocks, hasn’t been performing well in the past couple of years, as European and US growth has surged. With equity returns up 20%-30%, it’s incredibly hard to outperform the market cap-weighted index. So while minimum volatility is good and popular in a crisis, in recovery it starts to lag behind. Hence the factor hasn’t seen as much flow as it did three to five years ago.
But as minimum volatility flags, equal-weighted indices are surging. “It has the opposite profile to minimum volatility,” says Goltz. “They tend to do well in a thriving market, but relate poorly to the market when the market declines. This is simply because you’ll get a lot of exposure to smaller stocks, and often these are more sensitive to market movements.”
Value strategies outperformed many beta strategies by a huge margin during the crisis of 2000/2001, so a look back over the past 15 years shows their returns to have been high. But they didn’t perform so well in the financial crisis of 2008, because the highest-ranking value companies – such as banks and other traditionally stable organisations – were suddenly exposed.
Meanwhile quality indices, which give weight to high-quality, robust balance sheets rather than an Enron-style appearance of quality with no cash behind it, tend to do better in crisis markets, as quality is not tied to market cycles.
The key for anyone looking to employ smart beta is to focus on the intended outcome. It’s a matter of asking whether the index you’re considering using is fit for that objective, and how it will perform – both in the current market environment and in the future. And, of course, being flexible. “A multi-strategy approach is perhaps the most viable,” says Goltz.
“Each model has its merits over time, and often at different times, so why not combine them and invest an equal portion into each?”
Volatility and value, for example, have been known to combine well, especially in times of crisis, like the crash of 2008. A minimum volatility approach may also pair well with a momentum strategy. Or value and quality: quality companies are desirable but they tend not to be cheap. By combining value characteristics and quality you’re improving the earnings potential but getting a better balance. Meanwhile, a combination of value and momentum tends to work well together across cycles, a route to consider if following a buy and hold strategy.
“Investors may seek an investment benchmark that’s two-thirds market cap-weighted and one-third smart beta weighted,” says Lloyd Raynor, associate director in the pensions solutions group at Russell Investments. “And with that latter third split between strategies weighted on fundamentals and those weighted on risk.”
It’s important to remember that, while smart beta may be more passive than a purely active approach, one still has to actively make the call that the alternative index is going to outperform the market cap-weighted one. This is a key risk: the most difficult part can in fact be predicting what the market is going to do. You know that in a bear run a low volatility factor, for example, will out-perform the benchmark, and that in a bull run it will trail it. But do you know when a bull or bear run will happen?
It follows that how you navigate the world of smart beta will largely rest on expertise and experience. The good news is that it’s an adaptable model. “If you take the most common factors, and have no view on a particular diversification model, you can use the index,” says Goltz. “Or if you know more, you can take it as a benchmark, making the adjustments you wish to suit your knowledge and tastes, and measure performance against it. Or act passively, in fund tracking that index. How it’s approached is down to the expertise of the investors.”
As smart beta is driven by data, it’s also a matter of ensuring the data is trustworthy. How much of the methodology is built on live data, and how much is historical performance? The most effective indices are not over-engineered. They are simple and transparent, and publish their methodology for anyone to see and test. Investors looking at any index strategies and vehicles delivering those (including index funds or ETFs) need to apply due diligence as thoroughly as they would with actively managed funds.
It’s also crucial to ensure that smart beta is a good match for your needs and levels of risk tolerance – and those of any stakeholders. “There will still be periods when smart beta under performs,” says Raynor. “And certain sponsors, like sovereign wealth funds, may struggle to stay with you and the strategy in the long run.” Yet for those who are able to stay for duration, such strategies may just prove very smart indeed.
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