Putting the smart back into beta
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- Primrose Golden
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1 Putting the smart back into beta By: Lloyd Raynor, CFA, Associate Director, Pension Solutions Group EXECUTIVE SUMMARY: The use of market capitalisation-weighted indices has been the cornerstone of portfolio management for decades. However, the supremacy of market cap approaches as passive investment vehicles is being challenged by the strong academic evidence of a wide number of anomalies that can be regularly and systematically exploited. Smart beta approaches have arisen to take advantage of these anomalies. NOVEMBER 2013 THE RISE OF SMART BETA The reasons for market cap approaches being the cornerstone of portfolio management are very clear they are consistent with the now rather old modern financial theory (CAPM); they are objective and practical; they give a market view of relative value and they are practical as they automatically adjust to price movements, making them scalable and cheap to implement. However, a wide number of anomalies have been identified in academic literature over the past couple of decades that query the assertion that the market cap portfolio is a fully efficient approach to investing. In response many investment managers have grown into large and successful businesses built around exploiting one or more of these anomalies. In turn the investment industry is becoming increasingly cognisant of the difference between factor exposures that can be manufactured systematically (smart beta) and true sources of active returns (alpha). This has given rise to a host of alternative or strategy indices such as style, fundamental, stability and risk factor indices that may offer more attractive risk/return profiles than market cap. Exhibit 1 describes how smart beta fits between passive market cap and traditional active management: Russell Investments // Putting Smart Beta to work in portfolios 1
2 Exhibit 1: The new paradigm incorporating smart beta Source: Russell Investments. For illustrative purposes only DIFFERENT TYPES OF SMART BETA APPROACHES Smart beta refers to transparent, rules-based investment strategies, designed to provide specific exposures to market segments or factors. But what does this mean in practice? In reality we believe there are three types of smart beta approaches: Exhibit 2: The three types of smart beta Source: Russell Investments. For illustrative purposes only Alternatively weighted index approaches: These approaches rebalance the components of the broader market cap universe in an effort to benefit from contra-trading against the market portfolio. They depend on a belief that the market is prone to booms and busts and that there is value to be had from rebalancing back to a high capacity yardstick. A variety of such yardsticks exist, but fundamentally and equally weighted indices are the most common. For example, the Russell Fundamental Index Series, designed in partnership with Research Affiliates LLC, is formulated to deliver exposure to stocks based on measures of company size that are determined by fundamental accounting measures rather than by market price. In contrast, Russell Equal Weight Indexes provide an approach to investment that is agnostic to the weighting of each stock. Russell Investments // Putting Smart Beta to work in portfolios 2
3 Cumulative Returns Style/factor beta approaches: These approaches allow for a targeted exposure to certain factors, factors that may outperform the broad market over the longer-term, or alternatively deliver a similar level of return with lower risk. For example, the Russell Defensive Index is used to manage exposures to the historically superior payoff and lower risk of high quality, low volatility stocks. More generally however, the Russell Axioma Factor Indexes allow investors to gain exposure to a wider array of factors than volatility, including momentum and leverage amongst others. In practice certain factors are likely to be more reliable than others in terms of long-term outperformance or risk reduction. The Russell Axioma Factor Indexes allow investors to time their allocation to exposures, either by themselves or by delegating to parties with expertise in this area. Focused exposure approaches: As well as investors seeking out exposure to factors, they also seek out other forms of focused exposure. For example, the Russell Geographic Exposure Indexes are composed of developed market companies with significant revenue derived from emerging markets. These indices allow investors to gain exposure to emerging markets growth using developed market instruments and provide a complementary approach to direct emerging market investments. EXAMPLES OF HOW SMART BETA CAN BE INCORPORATED INTO YOUR PORTFOLIO The smorgasbord of smart beta approaches may provide an intellectual feast for fiduciaries and investors, but the challenge they face is how to embed them within the framework of a traditional institutional portfolio. Here we describe three uses for smart beta portfolios. Removing unwanted factor exposures One appealing use of smart beta is to control for unwanted exposures within portfolios. As can be seen in exhibit 3, a number of factors have had a negative payoff over the longterm: Exhibit 3: Factors with a negative payoff (31/12/94 to 30/06/13) 20% 0% -20% -40% -60% -80% -100% Volatility Leverage Market Sensitivity Size Source: Russell Investments and Axioma Russell Investments // Putting Smart Beta to work in portfolios 3
4 Smart beta approaches can control for these exposures at relatively low cost if investors believe that the negative payoff will continue. The most obvious example of this has been investors avoiding the negative return associated with the historically crowded space of high volatility stocks. Instead they have chosen to invest in the converse, low volatility approaches. Introducing wanted factor exposures (short-term) As can be seen in exhibit 4 below, returns to equity portfolios are explained by the return on: the Market; factors such as Size, Value, Momentum and Volatility; and stock specific factors (alpha). Exhibit 4: Attributing returns Jun 97 Jun 99 Jun 01 Jun 03 Jun 05 Jun 07 Jun 09 Alpha Market Size Value Momentum Volatility 7 years rolling excess returns Source: Russell Investments. Manager Universe data; Cyclical (style); and structural factor returns Factset Given this, active equity management can consist of both bottom-up stock selection as well as equity factor timing. Those investors with the capacity to time factor exposures can own their portfolio, determining which factor exposures they want and having an ability to measure and manage these exposures in real-time to target desired exposures to reflect the current market outlook. And while it may be hard for investors to build up smart beta timing expertise in-house, in practice there are a number of outsourced providers willing to offer such capabilities. Introducing wanted factor exposures (long-term) A further use of smart beta is to incorporate it into a structural benchmark. For example, a pension fund may believe that it needs to ensure a less volatile equity portfolio than the market as a whole and may therefore decide to use the Russell Global Defensive Index as the structural benchmark for some of its active managers. Such a long-term structural position can offset the tendency of most active managers benchmarked against market cap indices to hold stocks that are more volatile than the index. That same pension fund may also be concerned to avoid the historical booms and busts of market cap exposures, and diversify such cap weighted exposures by benchmarking a portion of its equity portfolio to the Russell Fundamental Index family. CONCLUSIONS Smart beta refers to transparent, rules-based investment strategies that can come in a variety of flavours used in a variety of ways. Far from being a busted flush, smart beta strategies are here to stay given the very tangible benefits that they can bring to investors in the management of their portfolios. Russell Investments // Putting Smart Beta to work in portfolios 4
5 ABOUT RUSSELL INVESTMENTS Russell Investments provides strategic advice, world-class implementation, state-of-theart performance benchmarks and a range of institutional-quality investment products, serving clients in more than 35 countries. Russell provides access to some of the world s best money managers. It helps investors put this access to work in defined benefit, defined contribution, public retirement plans, endowments and foundations and in the life savings of individual investors. FOR MORE INFORMATION: Call Russell at + 44 (0) or visit Important information This material is not intended for distribution to retail clients. This material does not constitute an offer or invitation to anyone in any jurisdiction to invest in any Russell product or use any Russell services where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation. Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and, unless it relates to a specified investment, does not constitute the regulated activity of advising on investments for the purposes of the Financial Services and Markets Act Analytics and data provided by Axioma Inc. ("Axioma Data") were used in the preparation of this report. Copyrights ( ) Axioma, Inc. All Rights Reserved ( Such data may not be copied or distributed in any manner. The Axioma Data is provided "as is" exclusive of any warranty whatsoever, including, but not limited to, any implied warranties arising under the laws of any jurisdiction. Axioma's provision of the Axioma Data shall not be deemed to be investment management or advisory services. Any use of the Axioma Data for analyzing, managing or trading financial instruments is at your sole risk. Accuracy and completeness of the Axioma Data are not guaranteed. Neither Axioma nor any of its third party vendors shall be liable for any damages, including direct, indirect, incidental, special or consequential damages, or damages for loss of profits, revenue, data or use, incurred by you or any third party. Copyright 2013 FactSet Research Systems Inc. All rights reserved. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Any forecast, projection or target is indicative only and not guaranteed in any way. Issued by Russell Investments Limited. Company No Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS. Russell Investments // Putting Smart Beta to work in portfolios 5
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