We asked five investment experts how smart beta indices have performed against cap-weighted indices over the past year and what the investment outlook suggests about the prospect for different investment factors.
Charles Aram (head of EMEA, Research Affiliates)
Damian Leach (director of systematic strategies, Fulcrum Asset Management)
Harindra de Silva (president and portfolio manager, Analytic Investors)
Chris Woida (head of index solutions, Axioma)
Andrea Nardon (head of quant, Sarasin & Partners)
CHARLES ARAM, RESEARCH AFFILIATES
Smart beta indices have continued, generally speaking, to perform extremely strongly over the last 12 months, both in their own right and relative to traditional cap-weighted methodologies.
The RAFI Fundamental index, for example, which weights components based on economic footprint (book value, dividends, sales and cash flow) rather than size, returned 17.97% on
a one-year basis.
This compares favourably to traditional market cap-weighted indices, particularly within the large-cap space which returned 15.08% over the same period (figures as of March 31, 2017).
Moving forwards, our simulations suggest those investors with exposure to value, high-dividend and standard momentum factors stand to benefit most, with five-year expected excess returns of 1.61%, 1.10% and 2.72% respectively.
In contrast, quality and low-volatility factors are likely to fare far less well, reflecting a combination of current market conditions and stocks within the ‘quality’ segment of the market becoming expensive as investors have flocked to gain exposure to these securities in recent years.
There will always be a temptation to make judgements based on past performance, however the expected five-year excess returns of quality (0.29%) compared to other factors clearly demonstrates that ‘performance-chasing’ can leave investors disappointed and exposed to expensive, overcrowded and ineffective strategies rather than those factors truly able to deliver strong returns over the long term.
For investors, it is crucial to look forwards as well as backwards before deciding which factors they wish to have exposure to.
DAMIAN LEACH, FULCRUM ASSET MANAGEMENT
The appetite from investors to employ a variety of systematic investment factors within their portfolios continues to increase.
Contributing themes for this rise in interest include a need for greater transparency and lower costs, as well as disappointment with the performance of more traditional alternative investment strategies.
Discussion often revolves around the twin concepts of smart beta and alternative beta. While the lexicon of available strategies is becoming increasingly fluid, both refer to lower cost, transparent, systematic and diversifying solutions for investors.
Smart beta centres on moving away from conventional equity market capitalisation weights towards extracting underlying investment factors through a rules-based approach.
After decades of academic study and practical implementation, these factors have been shown to be persistent and explainable, and include momentum, value, size, quality, and low volatility.
Critically, smart beta focuses on an equity implementation, but extracting investment factors in a systematic manner does not have to be limited to equities; they can be applied in equal measure across multiple asset classes.
Doing so in a systematic way adds diversification to the list of benefits that investors can potentially receive.
Alternative beta goes beyond the equity-focused limitations of smart beta. These strategies take a number of familiar factors – such as momentum and value – and add other, similarly persistent investment factors such as short volatility and carry, that are then applied across multiple asset classes.
By doing so, investors can now gain access to a range of investment factors that are diversified not only by underlying strategy, but by asset class as well.
Alternative beta achieves this while maintaining the core tenets of transparency, accessibility, diversification, and the potential for improved returns.
Laid against a background of low expected returns from traditional asset classes, meagre returns from higher-cost alternative strategies, and an ever-increasing need for meaningful transparency and diversifying return streams, the outlook is bright for smart and alternative beta strategies, and for investors alike.
HARINDRA DE SILVA, ANALYTIC INVESTORS
Performance of the indices, whether they be smart beta or cap-weighted, has been very consistent with the returns of the factors.
Smart beta products that have had a tilt towards low beta in the rising market have not done as well – however, being in the rising market, that would have been expected.
Some of the other tilts, like quality and valuation, have also not been rewarded. If you just look at last year, the three biggest tilts you get in the smart beta portfolio (valuation, market capitalisation and low beta) have not been rewarded as highly as they have been in the past.
In general, you will see that the whole suite of smart beta products has probably underperformed cap-weighted index, whereas the ones that have tilted toward things like momentum have done quite well.
Overall, the performance has been very consistent with the tilts embedded in the strategies.
When you are forecasting investment factors, there are two components you must think about: first is the recent performance of the individual factors, because those that outperform tend to continue to outperform.
The second component is mean reversion, with some of the factors such as valuation and low beta having not been rewarded in quite a while.
Given how benign markets have been and the fact that the valuation has not worked well, the outlook for those two factors is quite positive.
If you were engaging in the factor rotation strategy, it is probably a good time to have more cheapness and more low beta in your portfolio.
CHRIS WOIDA, AXIOMA
We analysed the performance of 86 US factor ETFs with assets under management of $394 billion (€351 billion) over the past year to understand the drivers of outperformance.
We found that the two most important factors for predicting outperformance were beta (computed with respect to a broad US equity universe including both large and small-cap stocks)
and exposure to the information technology sector.
The rising market in the US over the past year rewarded high beta stocks, and the information technology sector outperformed the other ten sectors.
In addition, the interaction of historical beta and information technology proved more predictive than any other factor pair combination.
For investors, the most important takeaway from last year’s performance results was to understand what factor exposures the ETFs have and how they impact performance.
We also compared the performance of four minimum volatility ETFs which normally have a lower beta than a traditional market-cap weighted index.
During last year’s rising market, the higher beta of the SPDR Russell 2000 low-volatility ETF helps explain its better performance.
In addition, while both value and growth ETFs outperformed last year on average, growth’s outperformance was driven by its sector exposures (for example, in information technology) while value’s outperformance was driven by its style exposures.
ANDREA NARDON SARASIN & PARTNERS
Recently, the popularity of smart beta has been at its peak, with many suggesting its superiority over anything else, including both active and passive fund management.
We have seen a proliferation of new products and players in the markets, and smart beta/risk premia/quant/systematic investing all generally share the same exploitations from factor returns that one gets in a rule-based investment process, leaving no room for discretionary overlay.
There is an expectation for products to perform similarly. However, as they have been created to exploit particular aspects of a factor, we have seen some disparity in smart beta.
In factor terms, last year we saw a good level of consistency in factor performance across the three big markets: the US, Europe and Japan.
Momentum factor struggled towards the end of last year but remained the dominant player in the US and Europe, and we have subsequently seen it rebound quite nicely again lately.
Value has ‘surprised’ us by returning stunning numbers in all regions, including Japan.
The only factor that disappointed, particularly in the US and Japan, has been size premium, however given the current uncertain political and economic climate, this is somewhat justified.
We generally don’t like to apply timescales to factors as we prefer to maintain a consistent proposition, and we believe it can be a difficult task to perform correctly, often detracting value.
However, with regards to our investment outlook for factor prospects, we do expect low volatility premium to perform well, as it has done since the beginning of this year, and we expect momentum to continue on its previously mentioned rebound.
Looking at value, we believe it has lost steam as of late, despite the solid numbers it has delivered since the beginning of 2017.
©2017 funds europe