The success of smart beta exchange-traded funds has been hard to miss, but there has been a lack of conversation around how these products can be applied within strategic and tactical portfolios.
Thierry Roncalli, Head of Research & Development at Lyxor Asset Management.
A recent thought leadership piece from Lyxor, the asset management arm of Societe Generale and a leading provider of ETFs in Europe, has provided some insight into the potential applications of factor-based ETFs in both long-term portfolio construction and short-term timing.
Factor-based smart beta ETFs offer a more focused exposure to the underlying risk premiums that drive broader smart beta strategies. While ETFs such as the Powershares FTSE RAFI range provide an excellent core equity exposure, the fundamental weighting of the strategy can lead to factor exposures within the fund such as small size and value. Through a factor-based ETF an investor can achieve a purer exposure to the underlying factor, providing a focused tool for enhancing returns and managing risk.
According to Thierry Roncalli and Jean-Charles Richard, quantitative researchers at Lyxor: “Traditionally, asset allocators have constructed portfolios by diversifying across asset classes and, within individual asset classes, diversifying across geographical markets, sectors and industries. A factor-based allocation approach requires a rethink of this traditional method. But diversification across risk factor strategies makes a great deal of sense, particularly since the past correlation levels between individual factors have been quite weak.”
The most prominent factor-based ETFs are based on variations of the momentum, low-risk, small size, quality and value factors. These have been shown to provide statistically significant excess returns over market-cap-weighted indices and are also grounded in sound financial theory.
In the construction of long-term strategic portfolios, factor ETFs can be combined to create portfolios which have the potential to capture the majority of excess returns offered by active managers. According to a report published on the performance of the active managers of Norway’s Government Pension Fund, exposure to common risk factors contributed over 99% of the fund’s past variation in returns.
The low correlation of factor performance and the frequency of short- to medium-term periods of underperformance, provides a strong argument for combining factors in long-term strategic portfolios. Lyxor suggests an equal risk contribution approach to diversification. What this means in practice is that individual factor weights should be calculated so that each contributes equally to the overall volatility of the fund. That is to say, the higher volatility factors will receive a lower weighting in the fund and vice versa.
Another strategy would be to follow a dynamic allocation approach to benefit from the time-varying nature of the individual factor performance.“Unlike asset class returns, risk factor returns exhibit some persistence over the short term. In other words, how individual factors performed over the previous month or months has a significant chance of predicting performance over the next month,” assert Roncalli and Richard.
Lyxor’s dynamic allocation approach incorporates short-term market expectations into the asset allocation process in an effort to improve risk-adjusted returns. When backtested in the European equity market between 2000 and 2014, Lyxor found this strategy contributed 7% a year in excess returns and lower volatility compared to the market portfolio. It did experience a higher maximum drawdown of 63.2% versus the market’s 58.5%.
Lyxor, iShares and Deutshce AWM are among the European ETF issuers offering suites of factor-based ETFs which cover, amongst others, the low-volatility, quality, size, value and momentum factors.