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By David Stevenson –
In just a matter of months, smart beta has suddenly emerged out of a technical netherworld into the investment mainstream.
I’ve been banging on about various forms of smart beta for as long as I can remember, starting first with fundamentally weighted indices such as Research Affiliates’ RAFI suite, which are investable via ETFs offered by PowerShares, iShares and Lyxor, before moving on to low or minimum volatility indices popularised by the likes of iShares, SPDR, PowerShares and Ossiam over the last year or so. Not forgetting the many successful high-dividend indices and ETFs, such as SPDR’s ‘Dividend Aristocrats’ range linked to S&P Dow Jones indices.
As a rather adventurous investor my interest in smart beta shouldn’t be remotely surprising – I’ve long had a deep interest in value investing strategies and screens, making fundamentally weighted indices a sensible next step. Minimum vol indices are also a natural next step for any long-term orientated investor who wants to run as far away as possible from typical momentum-driven strategies boasting excessive turnover.
Yet what’s been so surprising is that more and more mainstream voices are beginning to embrace the smart beta revolution. To take one small example, just a few months ago my fellow Financial Times columnist Merryn Somerset Webb finally bit the bullet and declared that she too was buying into the revolution. This from a declared fan of actively managed investment trusts! Even The Economist magazine has recently caught the bug, declaring smart beta the next big thing in a recent article in the magazine.
But for me, an even more interesting development has been the degree to which mainstream investment groups have quietly been buying into the ideas behind smart beta. Almost as soon as my 29th April 2013 column on smart beta was published on ETF Strategy, I was contacted by Guinness Asset Management – dig beneath the surface and one rapidly discovers that their mainstream Global Equity Income fund is in fact a hybrid between a traditional equity income fund and smart beta. A core part of the investment portfolio construction process is built around value-driven fundamental screening strategies (that could easily be turned into an index), with a final active overlay. In fact, the more one searches, the more on discovers that a large number of active managers use a basic smart beta strategy of some sort and then overlay it with a final active stock selection process – the big question for any investor in these hybrid funds is whether the final active overlay really justifies the fees levied!
What’s even more encouraging is that the big investment-driven private banks are also quietly embracing the smart beta revolution. Again, just after my smart beta article came out for ETF Strategy, I was contacted by Lombard Odier, a private bank and investment manager, which has spent the last few years building up a strong in-house research team on the subject. This focus on passive and smart beta by the Switzerland-based house shouldn’t come as any surprise – under Chief Investment Officer Paul Marson they’ve also developed a country-based strategy that uses country indices (and resulting country-specific ETFs) as a way of capturing different investment sensitivities. With smart beta the focus has been on patiently testing all the different strategies within the smart beta ‘space’ and the table below is a fascinating summary of their research conclusions.
Lombard Odier Research on smart beta – from a report entitled ‘Smart Beta Equities: Seeking for Better Risk-Adjusted Returns’ by Jerome Teiletche.
|Approach||Capital / Risk distribution||Risk characteristics||Style Biases|
|Minimum Variance/Volatility||> Highly concentrated
> Highly sensitive to covariance
> High Turnover
|> Lowest risk
> Lowest beta ( β << 1)
> High tracking-error
|> Large cap
> Low volatility assets
|Maximum Diversification||> Highly concentrated
> Highly sensitive to correlations
> Moderately sensitive to volatilities
> High Turnover
|> Low/Medium risk
> Low beta (β < 1)
> High tracking-error
|> Low correlated assets|
|Risk Parity||> Diversified in risk
> Moderately sensitive to
covariance matrix parameters
> Medium Turnover
|> Medium risk
> β below but close to
> Medium tracking-error
|> Small cap
> Low volatility assets
|Equal Weight||> Diversified in capital
> Insensitive to covariance matrix
> Low Turnover
|> Medium to High total risk
> Low/Medium specific risk
> Medium to High beta
(β ~ 1)
> Low/Medium tracking-error
|> Small cap
Obviously, ETF-focused investors (ETF providers have been at the forefront of this recent smart beta revolution, turning numerous smart beta indices into accessible low cost investment products) should welcome all this renewed interest in smart beta by respectable institutions. At long last, we now have a middle road between traditional low cost passive strategies emphasising full market access and more concentrated, active fund strategies which tend to be costlier. For me, smart beta is a sensible middle-ground alternative to active fund strategies, but at a lower cost and with lower fund manager risk.
But this enthusiasm for the sector shouldn’t blind us to some very real risks. One of the biggest issues for me is that these quant-driven strategies can quickly descend into ever so slightly arcane language with the inevitable effect that the end investor loses track of why they’re actually putting their money in outcome terms!
And we also shouldn’t lose sight of the fact that these strategies wax and wane very substantially over time – there’s some evidence now for instance that quality stocks with an income bias are suffering mightily in the face of big momentum-driven money flows.
In fact, I’d go so far as to reverse the flow of tables in the Lombard Odier table above and start with the right hand boxes called Style biases. In my simplistic world I think that investors face a series of simple choices. They can either ignore style biases and go for full market access via a traditional passive ETF or they can accept that different styles do well over varying investment cycles. If you favour the latter view – which I do – your key first question then becomes whether a particular market or investment class is better suited to a value strategy, a growth at a reasonable price (GARP, also known as quality) strategy or a growth strategy. If growth is your thing, then I’d almost always recommend moving towards an equal-weighted index strategy or a focus on indices with a higher beta such as the FTSE 250 index here in the UK or the MSCI Emerging Markets index. (For those able to buy US-listed products, PowerShares and iShares, among others, offer specific growth-orientated ETFs which fit the bill). By contrast, if income is your thing, especially dividend income, then I’d almost always opt for a fundamentals-weighted strategy with a dividend bias (I particularly like the Lyxor SG Global Quality Income ETF). Last, but by no means least, if you are a defensive, cautious investor, then a minimum variance strategy will probably work best (checkout offerings from iShares, SPDR, Ossiam and Lyxor).
Of course, this style pathway process always brings with it time-based risks – that a particular style drift will falter during certain market cycles. To return to that earlier example, value-driven strategies, especially skewed towards defensive, quality equities with a sound income flow have had a tremendous few years but that may not be true over the next few years, especially if global growth does begin to pick up speed a tiny bit. If you are bullish – which I am, unusually so – then a switch back into equal-weighted strategies might be the sensible next step. Crucially, I’m now worried that minimum volatility indices may begin to serially underperform as the secular equity bull market moves into next gear in the autumn! Maybe, just maybe, a focus back on to cyclical sectors might be the next smart thing for the uber-contrarians? Where are the smart beta strategies for these especially adventurous types?