SPONSORED FEATURE: Smarter than beta

Aberdeen_sponsored_picture‘Smart beta’ investing is rapidly becoming a popular alternative to both conventional passive management and traditional active management. Within equities, it is based on tracking an index whose component stocks are weighted by something other than their market capitalisation. Its aim is to systematically harvest individual or multiple ‘factor premia’ – those sources of risk that compensate investors with returns such as Value, Quality, Momentum, Small Size, and Low Volatility which arise and persist in equity markets due to behavioural and structural anomalies – in order to enhance performance, lower risk, or both. Aberdeen Asset Management’s proprietary and exclusive SMARTER Beta™ equity capability is an example of the latter approach that focuses on simultaneously enhancing performance and lowering risk.

Smart beta can be viewed as a third approach to investing (passive management through market capitalisation weighted indexing and active management being the other two) that combines the benefits of both active and passive management. Specifically, smart beta aims to achieve above-market returns or below-market risk, or sometimes both, by gaining targeted exposure to ‘factor premia’ while retaining the numerous benefits of conventional indexing such as simplicity, objectivity, transparency, and relatively low costs.

There are a number of smart beta indices that rebalance to an alternative set of weights and they fall into three categories with a focus on return, risk, or both return and risk:

1) Return focused
   • Equal weighting: where all companies in an index are weighted equally, irrespective of how large or small. Such indices have a small company bias relative to the corresponding market capitalisation weighted index;
   • Fundamental weighting: where companies in an index are weighted according to their economic size using, for example, an average of stock weights proportional to sales, dividends, cashflow and book value (the reason for averaging is that, taken individually, these simple measures all have flaws). Fundamental indices break the link between stock prices and weights and have a pronounced, albeit dynamic, value bias relative to the corresponding market capitalisation weighted index;

2) Risk focused
   • Risk weighting: where companies in an index are weighted according to their volatility with the aim of improving portfolio efficiency by making assumptions about future volatilities and/or correlations, generally based on historical observations. Risk weighting includes volatility weighting, equal risk contribution, and volatility minimisation approaches using an optimisation (e.g. risk-efficient, maximum diversification, minimum variance, and targeted volatility); and

3) Return and Risk focused
   • ‘Factor premia’ weighting: where companies in an index are weighted according to their factor exposures – those sources of risk that compensate investors with returns. This can be implemented via long-only (‘factor premia’) and long-short (‘alternative factor premia’) strategies. ‘Factor premia’ are broad, persistent forces that exist both across asset classes (where macroeconomic factors determine levels) and within asset classes (where individual factors determine dispersion) and ultimately drive the risk and return profiles of equities, bonds, currencies, and other asset classes. Within equities, individual RIPE FactorsTM (i.e. those factors that are Robust, Intuitive, Persistent and Empirical) include Value, Quality, Momentum, Small Size, and Low Volatility. Multifactor strategies, such as our proprietary and exclusive SMARTER Beta™ equity approach, employ a selected combination of various individual factors.

Empirical research confirms that these alternatively weighted indices, and hence the mutual funds tracking them, outperform relative to market capitalisation weighted indices with similar or reduced risk characteristics.

All of these smart beta approaches have three features in common. Firstly, they are not reliant on market capitalisation weights; secondly, they systematically rebalance back to a set of target weights where the periodic rebalancing captures the mean reversion of stock prices in a simple, robust fashion; and, thirdly, they are highly diversified in order to effectively exploit the negative cross-sectional correlations and noise inherent in financial markets.

SMARTER Beta™
Although there is a wealth of academic and empirical research demonstrating that Value, Quality, Momentum, Small Size, and Low Volatility each outperform over the medium to long-term, it is important to realise that on an individual basis these factors can move sideways or underperform for significant periods of time, sometimes a year or more.

Crucially though, such factors are lowly correlated, or even negatively correlated, with each other because they tend to outperform at different stages of the market and economic cycles. For instance, Low Volatility and Quality tend to perform better during an economic slowdown whereas Value and Small Size typically outperform during an economic recovery. Momentum generally performs well except at the inflection points of the market cycle. This correlation benefit in turn provides the opportunity to meaningfully increase risk-adjusted returns at the portfolio level by blending the individual factors in a multifactor approach in such a way that there is persistent positive exposure to all the RIPE Factors™ in order to reap the full benefits of factor diversification.

At Aberdeen Asset Management, with over a decade of experience in factor-based investing, we advocate a multifactor approach that aims to provide simultaneous positive exposures to all targeted RIPE Factors™ – even when applied to a single factor product like Value, for example – as we believe this to be superior to a single factor approach.

This is a key point as many competing single factor designs have factor exposures that, more often than not, are underexposed to non-targeted factors e.g. Value often has a negative exposure to Momentum, or even low beta, due to negative correlations. Given that all RIPE Factors™ are engineered to provide risk-adjusted excess returns over the medium to long-term, we believe this to be a design flaw in competing designs and one that we have consciously corrected in our multifactor approach.

Our SMARTER Beta™ equity indices include eight multifactor index families – Balanced Multifactor, High Income Multifactor, Value Multifactor, Quality Multifactor, Momentum Multifactor, Low Volatility Multifactor, Small Size Multifactor, and ESG Multifactor – across a range of global, regional, and local developed and emerging markets.

Conclusion
Interest in smart beta products, and multifactor strategies in particular, is mounting. Investors see the advantages of conventional indexing but are keen to obtain higher risk-adjusted returns and are sceptical of their ability to select active managers who can consistently outperform. Smart beta, and Aberdeen Asset Management’s proprietary and exclusive SMARTER Beta™ equity capability, is thus a third approach to investing that provides a pragmatic and cost-effective core solution to current investor needs.

David Wickham is Senior Investment Director at Aberdeen Asset Management

Important information: FOR QUALIFIED OR PROFESSIONAL INVESTORS ONLY – NOT FOR PUBLIC DISTRIBUTION

The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested. Smart Beta strategies, when compared to traditional indexes, can be more costly, risky, and have extended periods of underperformance. In addition, portfolio turnover and rebalancing costs can be higher than traditional indexes. These strategies can also employ complex trading strategies that expose an investor to a higher risk of loss including long and short, leverage, and hedging. The underlying securities held in a Smart Beta portfolio can also be more risky including, but not limited to commodities, high yield bonds, options and currencies. They present the risk of disproportionately increased losses and/or reduced gains when the financial asset or measure to which the strategy is linked changes in unexpected ways. This marketing document is for information purposes only and should not be considered as an offer, investment recommendation or solicitation, to deal in any of the investments mentioned herein and does not constitute investment research as defined under EU Directive 2003/125/EC. Aberdeen Asset Management does not warrant the accuracy, adequacy or completeness of the information contained herein and expressly disclaims liability for errors or omissions in such information and materials. Any research or analysis used in the preparation of the information has been procured by Aberdeen for its own use and may have been acted on for its own purpose. Some of the information may contain projections or other forward looking statements regarding future events or future financial performance of countries, markets or companies. These statements are only predictions, opinions or estimates made on a general basis and actual events or results may differ materially. The reader must make their own assessment of the relevance, accuracy and adequacy of the information contained in this document and make such independent investigations, as they may consider necessary or appropriate for the purpose of such assessment. Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither Aberdeen nor any of its employees, associated group companies or agents have given any consideration to nor have they or any of them made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, any person or group of persons acting on any information, opinion or estimate contained in this document. Aberdeen reserves the right to make changes and corrections to any information in this document at any time, without notice. Issued in the United Kingdom, Norway and EU countries by Aberdeen Asset Managers Limited. Authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered in Scotland No. SC108419. Registered Office: 10 Queens Terrace, Aberdeen, Aberdeenshire, AB10 1YG. Issued in Switzerland by Aberdeen Asset Managers Switzerland AG (AAMS). Authorised and regulated by the FINMA in Switzerland. AAMS holds a distribution license from FINMA.  DH: GB-190517-32590-1

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