The use of smart beta investing continues to grow. Our panel, made up of both providers and users, discusses what the strategy actually means, how it should be used and the kind of pitfalls that may arise when using this innovative investment technique.
Nizam Hamid (head of ETF strategy, WisdomTree Europe)
Chanchal Samadder (head of UK and Ireland ETF sales, Lyxor)
Neil Morgan (senior pension trustee, Capita Asset Services)
Jose Garcia-Zarate (director of ETF research, Morningstar)
Manuela Sperandeo (Emea head of specialist sales at iShares, BlackRock)
Funds Europe: Smart beta has been described as the middle ground between active and passive strategies. Is this an apt description and how do you think fees should reflect this?
Nizam Hamid, WisdomTree: I think definitely when we talk to a lot of clients, they do perceive it as being the middle ground. They do see it as that sort of next step from the pure, passive, super-cheap beta, so that kind of plays into fees, where clearly pure market cap, very commoditised pure beta products are incredibly cheap. Single-digit basis point type of products are very hard to differentiate one from the other. The middle ground of smart beta has so many different varieties and themes and flavours, that actually you are adding different amounts of value.
Chanchal Samadder, Lyxor: That’s where we as the industry have placed it, between pure beta and alpha. But in terms of risk/reward, it can be very different in terms of strategy. So it’s a very broad brush, some strategies are very close to market cap beta and they don’t offer a great deal of deviation from standard benchmarks. From a pricing perspective, you would say again that it is the middle ground, so more expensive than market cap weighted beta, but less expensive than active beta.
Neil Morgan, Capita: First of all, smart beta is an active strategy, because the stock weights are going to be different from market cap stock weights and market cap is still very much the benchmark. When smart beta first started off, it was giving simple and transparent exposure to well-known risk factors in a cheap way. There’s a danger of it morphing from active quant into smart beta, so lots of active quant managers are rebadging themselves as smart beta.
So, the more opaque and more complex these strategies become, the higher the fees. But for those active managers that are going down the smart beta route, and are simple and transparent, the fees are justifiably low, quite near passive, traditional market cap passive fees.
Manuela Sperandeo, BlackRock: The last time we checked, we estimated in excess of 800 products globally, and around half of those actually had a TER [total expense ratio] below 50 basis points. We’re starting to see increasing fee pressure, and an increasing number of products, and providers entering the space with both traditional asset managers and quant managers rebranding themselves as smart beta players. So it is definitely an industry where we’re seeing a lot of product proliferation.
Jose Garcia-Zarate, Morningstar: It’s kind of a middle ground between active and passive. The key differentiation aspect is obviously the rules-based framework and the appearance of these strategies. It’s just basically doing what active managers have been doing for many decades. A rules-based system, incorporated into ETFs. Then there is an interesting debate to be had as to whether the new strategies come into the marketplace, fit into that transparency rules-based framework or are they something completely different.
Morgan: Trustees find it very difficult. There is a proliferation of these different products. I think there’s a danger of trustees and investors in general being mis-sold products because there’s so much back-testing and data-mining now, based on just ten years’ worth of back data. Different definitions of factors and so on. So a lot of it is just based on past performance when it worked well purely because of chance. But it’s not necessarily going to work in the future.
Hamid: An argument against that would be, WisdomTree have actually been running live strategies for ten years. And if we’ve got a live ten-year track record on the majority of our strategies, you can see the performance. It’s a function of fortune, I guess.
Morgan: We’ve talked about the proliferation of products; as an example, there are so many definitions of quality, about 20 or 30, something like that. There’s that wonderful quote, ‘If you torture the data for long enough, eventually it will confess,’ and I think in a lot of cases that is what has been happening.
Hamid: Well, I think that’s the value conversation we have with clients where they appreciate having a live track record. And at some points, we will underperform market cap weighted indices. Other parts of the cycle we outperform. But it’s good for clients to actually see that and understand it.
Samadder: It’s the same with active strategies as well, any new strategy is going to be based on some kind of historical back test. What we found in conversations with investors is yes, they want to see a longer live track record of these products versus a vanilla market cap product, which ultimately is judged on just pure tracking error vs the benchmark.
Sperandeo: Also, the benefit of a smart beta strategy is that they are very transparent.
Morgan: Most of them are, but some aren’t.
Sperandeo: I think there is some complexity that makes the due diligence process longer, but the transparency is a defining attribute of smart beta strategies. Like tradtional index strategies, smart beta strategies follow pre-set rules to determine the factor that you want to target, how you define it, how you measure it. A lot of the misunderstanding about these products arises when there is no clarity about the definition of the factors and how they are supposed to behave in different market conditions given their inherent cyclicality.
Hamid: It’s all about education. So that has become the number-one challenge for all the providers here.
Morgan: You’re right. The trustees really have to understand what they’re buying into, and if you’re investing in just a single-factor strategy, emphasising right at the beginning. The work starts at the beginning before you invest, in terms of looking at their objectives and looking at their investment beliefs.
Hamid: And even sort of restructuring style bias of their portfolio, is part of what they need to consider.
Funds Europe: Can factor timing work and in what circumstances should it be considered? It also, to me, sort of looks a bit like an active strategy. Is that a fair comment?
Garcia-Zarate: Anything that comes with timing to me is anathema. It’s as simple as that. We don’t expect the investors to be able to time the market, you shouldn’t expect them to be able to time factors. Diversification is the way to go when building factor-based investment portfolios.
Funds Europe: Even if the factor has been underperforming for a long time?
Garcia-Zarate: There is this question. I mean this is where the cyclicality of these factors actually comes into the equation. Are you able to actually spot the right point of entry or are you actually trying to follow a trend?
Hamid: It’s interesting, because we talk to clients where their investment committees are now looking at which factors they want to allocate to. Previously, they would have looked at which region they would allocate to or which country. So there’s an evolution of investment committee process where understanding is about do they want to be in a low volatility factor, or value, or growth? That sort of discussion becomes part of the investment process. So it’s not about pure market timing as such. It’s about how do you want to position your portfolio?
Morgan: You start with the objectives, so you’ve got to decide why you want smart beta. If you want to dampen down the volatility, you might go for low vol. If you think there’s a reward from value over the longer term, you might go to some value factor. In terms of factor timing, yes I think it’s very difficult. It’s just like asset allocation. A lot of people are now going into factor timing because they believe they can do it as well. I think in terms of if you’re going into a single-factor strategy, there’s probably an argument for looking at whether valuations of that factor are at an extreme level. To guard against extreme valuations, pension schemes should be investing in multi-factor strategies to diversify that risk of getting into a factor at the wrong time, for example.
Samadder: The first question we were asked when we launched our single factor range is, how do we allocate between these and how do we time them? There is an element of market timing when you are doing any kind of allocation, because you are trying to buy a low price and get out on a higher price. So what we saw when looking at various methodologies of allocating between factors was that the simple equal weighting worked the best. You can get very complex into these things but if you look at the complexity to return, the risk/return perspective, simple equal weights worked very well.
Sperandeo: For those investors which have enough appetite for risk, they could start from an equally weighted allocation, with four or five factors they believe have an interesting diversification pattern, and then tilt towards one factor or the other to pursue incremental returns. There are many predictors that have been widely researched over the years, valuation for example, or dispersion, meaning the opportunity set that factor strategies have in the current market. When all stocks behave similarly, there is little benefit to be gained by deviating from market-cap weights. In contrast, when there is a high degree of dispersion across individual stocks, any over- or underweights relative to the market portfolio have the potential to drive meaningful performance differences. Many of the more sophisticated factor investors have now transcended traditional asset classes, and they now think in factors terms when determining their optimal asset allocation.
Funds Europe: We’re obviously in a low-growth environment at the moment. Which factors are going to bring the best returns in equities and fixed income?
Garcia-Zarate: Well, there hasn’t been much in the way of exploration of factors in fixed income. The whole smart beta concept has been very equity-focused. There are substantial, practical impediments for the development of fixed income.
Hamid: I think there’s huge scope in fixed income. Literally every client I speak to wants to know when we’re going to bring out strategies in the fixed income space.
Garcia-Zarate: In research terms, we are decades behind fixed income factors as well.
Hamid: The core problem I think, for a lot of clients, is that some of the fixed income benchmarks they just perceive as being too naïve. So simply having benchmarks, which effectively have as much debt as the corporates that issue the most debt, isn’t really the most logical thing that you might want to do. And especially if you go into the corporate bond space as well. So I think that’s really where the value added can be.
Garcia-Zarate: There is an interesting discussion about that. Doing market cap in fixed income does not look like a good idea in principle.
Hamid: But that’s where people are typically today. That’s the problem.
Garcia-Zarate: I must say though, that once one starts assessing the nuances of fixed income investing, the message that market cap is not a good way to go is not as solid as it seems at first sight. We’ve seen some ETFs, on the fixed income side, that have tried to weight or counter the potential shortcomings of the market cap on the fixed income world. But essentially you end up with a very defensive strategy. I mean, if you apply the quality test to, for example, the eurozone government bond market,you end up with a German government exposure, so you might as well just buy the market cap and avoid paying the extra cost for a smart beta product.
Hamid: But there are definitely clients wanting a solution to the naivety of the benchmark.
Morgan: Everybody’s searching for yield now, in terms of what trustees and pension schemes are doing. Obviously gilts are extremely low yielding, so they are looking to diversify into other fixed income asset classes that perhaps bring some more yield, like corporate bonds and emerging market debt. It also goes back to trustees of pension schemes deciding what their objectives are, whatever the economic environment. And things have changed post-Brexit, so trustees are having to look at what the implications are, in terms of the covenant of their employer. Also, what implications are there for different asset classes. We’ve already seen some impact on sterling for instance. So it’s really about making sure you’ve got proper objectives in place, and your investment beliefs, and then investing accordingly in whatever smart beta products you think are appropriate for that strategy.
Samadder: With any fixed income, there’s not a great deal you can do other than take duration or credit risk, these are the only two variables investors have to play with, maybe some liquidity risk as well. It’s very difficult in this current environment.
Hamid: Also in the low interest rate environment, you’ve got people searching for yield in equities. That’s been a big trend, because you’re not getting that in fixed income, so people are looking for substitutes.
Samadder: I agree that investors have been almost forced into equities in the hunt for yield, but it is an asset class some investor have typically not been entirely comfortable with because of greater historic volatility and drawdowns compared to bonds. Hence we’ve seen a lot of money going to quality dividend strategies, because they are explicitly designed to deliver income whilst aiming to protect against drawdowns.
Funds Europe: As money flows into certain strategies, low vol for instance, could their popularity lead to a smart beta crash or crowding?
Samadder: No, is the straight answer. First of all, not a broad crash certainly, because most smart beta strategies and risk factors are uncorrelated with each other. So you will see periods of underperformance and outperformance of certain factors. At some point you will see momentum suffer, but at the same time you would expect value to outperform, so we don’t see it happening. In fact many of the risk factors have low correlation with each other. Crowding is possible in any kind of strategy, not just smart beta strategy. But it really depends on who’s owning that stock, the diversity of views of the owners of that stock. If you look today in terms of the overall stock ownership by smart beta strategies, it’s relatively low compared to other owners of those same stocks.
Sperandeo: The question of crowding for minimum volatility comes out a lot. In the past 12 months ending June 30, 2016, there were $7.8 billion flows into a total of 17 ETF min vol strategies in the US only, so of course it is a big figure and everybody’s looking at it.
We ran some research in terms of what percentage this represents of the broader equity market capitalisation, to assess how big are these strategies versus the growth of the equity index business and what is the capacity. We estimate they represent just 0.033% of total equity market capitalisation of the underlying securities. Capacity in these strategies is large because traditional active mutual funds tend to overweight high volatility stocks.
On the point of valuations, the factor itself has been performing quite well, but current valuations of min vol strategies are not high relative to historical norms, and are consistent with the observed outperformance of these strategies during periods of high uncertainty.
Hamid: Well, if you think about the comments which were made about a smart beta crash, it’s a question of the valuation drive that’s happened. Min vol valuations have been driven to a premium since 2012, price-to-earnings in min vol has actually gone up by 49%. It’s now at 20% premium to the market PE in the US. And I think it’s not a question of it’s a crash. It’s a question that money flows will drive those valuations. It doesn’t make them less attractive in terms of the factor they’re representing, but clearly the valuation relative to the market, that dynamic does change.
Morgan: If you look at the equity market, the equity market has crashes as well, because it gets to a stretched valuation level, so if some of these factors are getting to stretched valuation levels, there may be no room for them to go up any further, so that the realised returns going forward are going to be zero on that basis. But there’s also a chance of mean reversion and a significant downturn, so valuations do matter.
Hamid: What I didn’t accept in Rob Arnott’s argument (see ‘Crash landing’, page 6) was that it was a money flow issue, because the period under analysis was so long, that it didn’t actually cover the period when money has actually been flowing into the strategy. So, if you take a ten-year view of the valuation treatment that’s been driven in these strategies, what actually happened five years ago, ten years ago, no ones’s actually been putting money really in any size into these strategies.
Garcia-Zarate: But there is an element of flows actually driving valuations up, even if it is a tiny part of the the market.
Morgan: A tiny market, that’s true. There is performance-chasing and some of these factors were overvalued, it’s as simple as that. Some factor investors are going to be disappointed. That’s a fact of life. If you are going into a single-factor strategy, it is worth looking at the valuation of that factor. More importantly, it’s perhaps looking at a multi-factor strategy and not putting all your eggs in one single-factor basket, to make sure you are diversifying if you’re using a smart beta strategy.
Samadder: If you look at how they’ve behaved so far in a real-life environment, minimum volatility is the best example because there have been products around, and we’ve gone through big drawdowns in the market. But they’ve done what they’re supposed to do.
Hamid: But interestingly, people want to have minimum volatility, but actually they could have had lower volatility by being in something which was never sold as being min vol.
Sperandeo: That’s why it’s so important that we give clear visibility on what is driving the performance, because then again the factor valuation, as it stands today, is not stretched. Providing such visibiilty is the first step to avoid any bad experience with these types of strategies.
Funds Europe: How does an investor’s time horizon impact the smart beta strategy they use? For instance, keeping out of fashion factors, such as value. Is it worth keeping those, because markets will obviously change to accommodate them at some point?
Morgan: It’s a longer-term strategy and the work starts at the beginning of any implementation. So if the trustees and the advisers believe that there is a value risk premium in the longer term and the data seems to indicate that, then invest in it, but maybe take account of the current valuation of value. But then when times are bad, when the value factor, or whatever factor it is, is underperforming, it is important to keep with the factor through that period of underperformance, because you are going into it as a longer-term investor. Now, I suppose there is the point that the value factor may stop working in the future, we just don’t know. But we’ve got about 50 years’ worth of data, so it looks as though it does work. And so the danger is that, after a three-year period, trustees look at any underperformance of the factor, and then say, “Well, actually this isn’t working, let’s bail out of it,” and then subsequently of course, it starts outperforming. So it’s important to stick with the factor if the investment belief is that over the longer term, there is outperformance to be gained from exposure to it.
Samadder: Holding on to a strategy for an entire economic cycle is needed to actually outperform. Clearly in a higher beta bull market, factors like low beta and quality are generally going to underperform. So investors should bear that in mind, but over the long term, they have been proven to work by very sound academic research.
Funds Europe: So, how long do you stick with a strategy that’s not been performing for years?
Samadder: It’s of course a question of profitability and resonance with investors. We saw fixed income ETFs launched many years ago but they had no assets in them for a long time and now they do. So it also comes down to giving investors time to see a real performance and better understand those strategies. With smart beta, most strategies have not been around for long enough.
Morgan: There’s too much proliferation, too much duplication, and certainly for ETF providers, there is a critical mass, obviously, where you have to get to, I guess, but many won’t. Nobody’s going to duplicate exactly somebody else’s strategy, right? So there are attempts at differentiation, but whether that differentiation has any economic value going forward, who knows?
Garcia-Zarate: If you come up with a new product, and you say, “Well, actually, this is a better way of capturing quality,” or whatever, then by definition you are saying that your competitors are not doing a good job by capturing the factor anyway.
Morgan: So much research has been done on these factors and you come up and say, OK, I’ve found this different definition of a factor that really works, trust me. Nobody else has found it and all you’ve done is data-mining.
Hamid: It’s certainly a case of people building core sets of factors that are available to clients. We’re not telling the clients when they should incorporate those into their portfolios. They exist as an opportunity, as a product set that they can choose to use, depending on their views as to how they want to position themselves.
Samadder: There was a paper which identified 300 factors and at the current rate of growth, you will have more factors than single stocks in 20 years’ time. The five we’ve already discussed are the ones that most of the market would argue genuinely add value.
Sperandeo: It goes back to your philosophy around targeting those broad persistent drivers of return that you think are here to stay – because they are backed by economic intuition, behavioural anomalies or structural impediments – and if you believe they are here to stay, then those are the reasons why you should not think about pulling out the product from the market. We launched minimum volatility in December 2012, and the first two years, minimum volatility was out of favour and nobody wanted it, but when market condtions became more favourable to these type of strategies, investor interest turned to them.
Garcia-Zarate: For an active house, it is much more difficult to actually justify keeping something that is underperforming, because essentially what you’re saying is that the guy at the helm is not doing a good job. You’ve got more flexibility in terms of actually keeping this broad range of products that you can choose from, because you’re selling building blocks rather than trying to sell the intellectual capabilities of a person managing a fund.
Sperandeo: Factor investing really helps in your active manager’s evaluation, and a lot of times actually you’ve had very capable value managers where performance has been detracted by the underperformance of value as a factor. So now we see more and more investors coming to us and asking us to decompose this type of performance, and you find that the investor has actually been able to add alpha through a single stock selection as well as sector timing and factor timing. The big detractor of performance has been the exposure to one underperforming factor. The ability to combine your active manager line-up with some single smart beta exposures means you don’t need to fire your manager. So interestingly, smart beta which many used to see as the biggest threat to active management, could actually become a very good complement to it.
Hamid: I think a lot of clients increasingly understand that active managers effectively are just offering them a tilt to what is a specific factor. And now we’re saying, “Well, you can buy that factor tilt in a much cheaper format, more consistently, because it’s quantitative.” If that’s the exposure that you want, be it value or growth, or small cap, or some other factor, buy it in a quantitative manner via an ETF.
Morgan: Where is the money that’s going into smart beta coming from? Some of it’s coming from traditional market cap, but also some of it’s coming from active management because people do realise that some of the traditional active management that’s being done provides a fairly static exposure to a particular factor. So if you can strip that out and get it more cheaply, then where does the traditional active manager go? I think a lot of them are having to think very carefully about what it is they’re trying to do going forward. Trustees of pension schemes can now get a cheaper exposure to some of the factors that they were getting more expensively previously through active management. So I think smart beta is force for good from that perspective.
Funds Europe: Where next for smart beta?
Samadder: Educating investors, helping them understand how to use them, combining factors etc, so I think that’s immediately the next area of growth.
Hamid: It’s actually just down to broader usage of products. Obviously it has been a fast-growing area, but in absolute terms, it still doesn’t dominate the landscape. I don’t think we need to build a whole raft of new products, to be honest.
Morgan: Definitely not, you certainly don’t need any more products. Strip it back to basics and really just focus on simple and transparent exposure to the well-known factors, rather than coming up with new factors through data-mining, or different definitions of factors, or different combinations of factors.
Sperandeo: I would agree, increased adoption by a broader audience (both institutional and retail) is the future and also the biggest test for smart beta. From a product perspective, the multi-factor space becoming more and more the battlefield, with new providers and assets going into the category. On the other hand, there’s still a lot of testing to do on how these products are performing out of sample, and a lot of education around the different ways in which factors get combined in these different solutions.
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