From Smart Beta to “Smarter Beta”
Enhanced factor design, a multifactor approach and efficient implementation have the potential to address many of the drawbacks of existing Smart Beta products.
Market Capitalisation Weighting
Passive investing through float adjusted, market cap weighted indices allows investors to capture the equity risk premium at very low cost. There is though considerable evidence that such products are not efficient in the sense they do not maximise risk-adjusted expected returns. In particular market cap weighting can lead to overly concentrated positions in individual stocks. Furthermore, market cap weighting often leads to significant exposure to sources of risk that are not rewarded over the long term, such as the Size and Growth factors.
Smart Beta seeks to address the shortcomings of passive investing by implementing rules-based investment strategies that target exposure to factors which academic research has shown generates excess returns over the long term. Examples of such factors would be Value, Quality, Momentum, Small Size & Low Volatility. The use of Smart Beta is now widespread.
However the huge popularity of Smart Beta in recent years has brought to the fore several concerns about many Smart Beta products, namely:
- The AUM following any particular Smart Beta factor cannot be controlled. This means generic factors can become crowded, giving rise to reduced returns and increasing the chances of sharp drawdowns.
- Individual Smart Beta factors that are highly likely to outperform over the long term can nevertheless underperform for considerable periods of time. For example the Russell 1000 Value index has underperformed the Russell 1000 index since the start of the Global Financial Crisis in the middle of 2007.
- The relatively infrequent rebalancing of many Smart Beta products (quarterly, semi-annual or even annual in some cases) can cause excessive factor decay. In addition, fixed rebalances that are telegraphed to the marketplace in advance make Smart Beta vulnerable to front running by hedge funds. This latter implementation issue will surely only become worse as Smart Beta AUM increases.
Below, we outline a framework for overcoming these challenges, which we refer to as “Smarter Beta.”
Smarter Beta: Enhanced Factor Design
There is no requirement to use generic factor definitions that can be easily commoditised and therefore more vulnerable to overcrowding. Research can lead to the development of enhanced versions of factors such as Quality, Momentum etc. For example, Quality is often thought of in terms of Return on Equity or Earnings Stability. An alternative approach which we have found performs particularly well is to define Quality in terms of Financial Strength, which favours those stocks with increasing liquidity, increasing profitability, decreasing leverage and low accruals. This definition can be further enhanced with sector specific metrics tailored to Financials.
Smarter Beta: Multifactor Approach
Individual factors are often lowly correlated, or even negatively correlated with each other because they tend to outperform at different stages of the business cycle and in different market environments. Momentum performs well when trends are established but does poorly during market rotations, whereas Quality usually outperforms when macroeconomic conditions are deteriorating and investors are becoming more risk averse. Chart 1 clearly illustrates that no one factor is the top performer every year.
The correlation structure of factor returns provides an opportunity to increase risk-adjusted returns at the portfolio level. This is done by blending single factors in such a way that we end up with a positive exposure to all targeted factors. Through such an approach, we can reap the full benefits of factor diversification. We find such a multifactor approach reduces cyclicality and drawdowns compared to single factors.
Smarter Beta: Optimisation & Implementation
The use of optimisation tools also offers many advantages. One example is the flexibility to neutralise unintended or unrewarded factor exposures and place limits on individual stock weights to avoid excessive concentration. Optimisation is particularly suited to the multifactor approach since it allows simultaneous targeting of multiple factor exposures.
Efficient implementation is especially important for those factors with higher execution costs, for example Momentum which has high turnover, and Small Size which is relatively illiquid. Optimisation allows trades only in the most significant changes in factor exposures, avoiding smaller changes in the middle of the distribution that are mostly just statistical noise. Switching to monthly rebalancing from less frequent rebalancing reduces factor decay and thereby increases exposure to targeted factors. Finally, not revealing trading dates to the wider market prevents possible front running by hedge funds.
Integrating Environmental Social and Governance (ESG) criteria
We believe another key dimension to consider in relation to Smarter Beta is ESG. We have identified both a need in the market for Smart Beta ESG and a lack of suitable providers. Specifically, we find that 76% of asset owners say they consider ESG in their manager selection process, but that only 24% of investors are implementing Smart Beta strategies that incorporate ESG information.
This disconnect can be readily addressed within the Smarter Beta framework outlined above. For example, companies involved in the production of tobacco or controversial weapons, for example, can be excluded from the investment universe. ESG factors can be targeted through optimisation in the same way as other factor exposures.
To summarise, we believe that enhanced factor design, combined with a multifactor approach and more efficient implementation have the potential to address many of the drawbacks of existing Smart Beta products that are available in today’s market place.
View the full Global Outlook publication below:
- Strategic Asset Allocation Outlook
- Corporate profits drive equity performance
- Value in the global energy sector
- From Smart Beta to Smarter Beta
- Improving returns by investing in concession infrastructure funds
- Gender Diversity: an economic and strategic imperative
RISK WARNINGThe value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.
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