SMART BETA ASSET OWNER IMPLEMENTATION STRATEGIES FURTHER FINDINGS FROM RUSSELL INDEXES GLOBAL SMART BETA SURVEY RUSSELL INDEXES

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1 SMART BETA ASSET OWNER IMPLEMENTATION STRATEGIES FURTHER FINDINGS FROM RUSSELL INDEXES GLOBAL SMART BETA SURVEY RUSSELL INDEXES DECEMBER 2014

2 Introduction In April 2014, Russell Indexes published the results of a survey, conducted in January, of the perceptions and adoption of smart beta among nearly 200 institutional asset owners in Europe and North America ( Smart Beta: A deeper look at asset owner perceptions ). This follow-up piece offers additional insights into how smart beta is being implemented, focusing on the survey responses of over 50 asset owners that currently have smart beta allocations. In recent years, the broad concept of smart beta has become a ubiquitous topic in the media and among investment practitioners. However, it s important to remember that smart beta does not denote a single investment strategy, but rather several distinct, index-based strategies. Each strategy has a unique objective and set of characteristics that enable investors to more precisely construct their portfolios as they seek specific outcomes, such as return enhancement, risk reduction, income generation or improved portfolio diversification. Among these strategies are equal weighting and fundamental weighting, as well as various factor strategies such as low volatility, momentum, quality and value. The range of individual strategies within the broad smart beta category is underscored within this follow-up to our survey. A key finding is that the majority of asset owners who have adopted smart beta are using more than one strategy, with a third including more than three in their portfolios. Fundamental weighting and low volatility were cited as the two most-used smart beta strategies. However, many investors are using fundamental weighting and low volatility in combination with each other, as well as with other strategies. The increasing combination of smart beta strategies within portfolios highlights the need for continued education, for better understanding not only of the how strategies are likely to behave individually, but also of how they are likely to interact with each other over time. As might be expected, our survey also found that the largest allocations to smart beta tend to be among asset owners who are using more than one strategy, as well as among those with the greatest numbers of assets under management. Additionally, respondents used different vehicles to implement smart beta strategies in strategic and tactical applications. Respondents preferred separate accounts, mutual funds and collective investment trusts for strategic use, and exchange traded funds (ETFs) and derivatives for tactical use. A key question is whether the growing adoption of smart beta will continue to drive increased ETF usage among institutional investors. At present, regardless of their choice of investment vehicle, survey respondents clearly indicated that they use smart beta strategies as part of both active and passive allocations in their portfolios. This follow-up analysis to our earlier report further demonstrates asset owners growing interest in and adoption of smart beta strategies as well as the need for continuing education about these new tools and how they can best fit within investment portfolios. We hope this additional information provides helpful insights for investors who are considering including smart beta strategies within their portfolios. Rolf Agather, CFA Managing Director, Global Index Research & Innovation, Russell Investments RUSSELL INDEXES SMART BETA: ASSET OWNER IMPLEMENTATION STRATEGIES

3 SUMMARY OF KEY THEMES: The majority of asset owners who have adopted smart beta are using more than one strategy. Low volatility and fundamental indexes are the most popular among asset owners who are currently using two or more smart beta strategies. Both low volatility and fundamental strategies are used by more than a third of asset owners who are employing two or more smart beta strategies. Similarities exist among asset owners making the largest investments in smart beta. Larger allocations are more common among asset owners using more than one smart beta strategy. Corporate asset owners and asset owners with AUM over $1 billion are also more likely to have larger smart beta allocations. Asset owners prefer different vehicle types for strategic versus tactical implementation. Respondents preferred separate accounts, mutual funds and collective investment trusts for strategic use. For tactical implementation of smart beta, ETFs and derivatives are the top choices in North America and mutual funds are the number one choice in Europe. Asset owners do not have consensus on whether smart beta replaces allocations for active or passive management. Asset owners who have already made smart beta allocations are more likely to view smart beta as a replacement for passive management than those asset owners who are still evaluating smart beta. European asset owners with smart beta allocations are more likely to view smart beta as a replacement for passive management than North American asset owners with smart beta allocations. Sample We conducted this survey in January The 181 asset owners who responded were drawn from Europe (52%) and North America (48%). Nearly 90% of the survey respondents either have direct responsibility for selecting equity investments or have roles in teams that do so. Roughly half of the respondents work for corporations or private businesses; a quarter work for non-profits or universities; and a quarter work for government organizations. Seventy-five percent of the respondents manage defined benefit retirement plan assets, 43% manage defined contribution plan assets, and 19% manage endowment or foundation assets. By AUM, 75% of respondents manage assets in excess of $1 billion, and 35% of these respondents manage assets in excess of $10 billion. The sample size of the survey is sufficiently large to allow for segmenting results on AUM size and region. The data in this paper is based primarily on the 51 responses from asset owners with smart beta allocations. 1 Europe sample includes some respondents from the Middle East. 03

4 GLOBAL SMART BETA FURTHER FINDINGS 1 The majority of asset owners who have adopted smart beta are using more than one strategy. Nearly 60% of asset owners who are using smart beta are using more than one strategy. EXHIBIT 1 Number of smart beta strategies used 4% 2% 24% 41% or more 24% Fundamental indexes and low volatility are the most common smart beta strategies among asset owners using more than one. Among asset owners who currently use two or more smart beta strategies, low volatility and fundamental indexes are the most popular used by 67% and 56% of respondents, respectively. Both low volatility and fundamental strategies are used by more than a third of asset owners who are employing two or more smart beta strategies. EXHIBIT 2 Strategy combinations among users with two or more smart beta strategies Low volatility & fundamental combinations 37% Low volatility combinations 30% Fundamental combinations 19% Other combinations 15% RUSSELL INDEXES SMART BETA: ASSET OWNER IMPLEMENTATION STRATEGIES

5 2 Similarities exist among asset owners making the largest investments in smart beta. Corporate asset owners and asset owners with AUM over $1 billion are also more likely to have a larger smart beta allocation. EXHIBIT 3 Asset owners with smart beta allocations over and under 10% $10B+ $1 to $10B Under $1B Non-profit, university Government Corporations or private business Total Population 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Under a 10% Allocation Over a 10% Allocation Larger allocations to smart beta are more common among asset owners using more than one smart beta strategy. Forty-two percent of asset owners currently using two (or more) smart beta strategies allocate more than 15% of their portfolio to smart beta. Asset owners using a single smart beta strategy are likely to allocate less than 10% of their portfolio to the strategy. EXHIBIT 4 What percentage of your organization s equity portfolio is invested in a smart beta strategy? 45% 40% 35% 1 Strategy 2+ Strategies 30% 25% 20% 15% 10% 5% 0% 0%-5% 6%-10% 11%-15% 16%-20% Over 20% 05

6 GLOBAL SMART BETA FURTHER FINDINGS 3 Asset owners prefer different vehicle types for strategic versus tactical implementation. 2 Eighty-two percent of asset owners are using external asset managers for strategic smart beta implementation. For the strategic implementation of smart beta, separate accounts and collective investment trusts are preferred in North America. Separate accounts and mutual funds are preferred in Europe. There was essentially no interest in using ETFs for the strategic implementation of smart beta in either region. Approximately 18% of asset owners are managing smart beta assets internally. EXHIBIT 5 For strategic uses of smart beta strategies, what vehicle type would you prefer? Europe North America All Respondents Separate account 35% 32% 33% Mutual fund 38% 11% 27% Collective investment trust 12% 32% 20% Manage internally 15% 21% 18% ETF 5% 2% For the tactical implementation of smart beta, ETFs and derivatives are the top choices in the North America, and mutual funds are the number one choice in Europe. Separate accounts and internally managed funds are preferred by less than 11% of respondents for tactical implementation of smart beta. EXHIBIT 6 For tactical uses of smart beta strategies, what vehicle type would you prefer? Europe North America All Respondents ETF 19% 31% 24% Mutual fund 29% 13% 22% Derivatives 10% 25% 16% Collective investment trust 19% 13% 16% Separate account 14% 6% 11% Manage internally 10% 13% 11% 2 At Russell, strategic implementation is viewed as a long-term allocation while tactical implementation is viewed as a short-term adjustment to a portfolio. The survey did not provide a definition for strategic and tactical implementation. RUSSELL INDEXES SMART BETA: ASSET OWNER IMPLEMENTATION STRATEGIES

7 4 Asset owners do not have consensus on whether smart beta replaces allocations for active or passive management. Asset owners who have already made smart beta allocations are more likely to view smart beta as a replacement for passive management than those asset owners who are still evaluating smart beta. Among asset owners who currently have a smart beta allocation, 39% identified it as an allocation for passive management significantly more than the 13% of asset owners who are currently evaluating smart beta and do not yet have an allocation. In both groups, around 20% viewed smart beta as an allocation for active management. EXHIBIT 7 What is smart beta a replacement for? Asset owners with a smart beta allocation compared to those currently evaluating. 100% 80% 60% 40% 20% 0% 39% 20% 37% Have a smart beta allocation 13% 21% 50% Currently evaluating smart beta Don't know Neither Passive Both active and passive European asset owners with smart beta allocations are more likely to view smart beta as a replacement for passive management than North American asset owners with smart beta allocations. Active Among asset owners in Europe with smart beta allocations, 44% view smart beta as an allocation for passive management while only 15% view smart beta as an allocation for active management. EXHIBIT 8 What is smart beta a replacement for? Regional breakout among asset owners with a smart beta allocation. 100% 80% 60% 44% 32% Don't know Neither 40% 15% 26% Passive 20% 0% 37% 37% Europe North America Active Both active and passive 07

8 APPENDIX APPENDIX 1 What percent of your organization s equity portfolio is invested in a smart beta strategy? 0%-5% 40% 6%-10% 22% 11%-15% 9% 16%-20% 11% Over 20% 18% 10% 20% 30% 40% Segment = Have smart beta allocation APPENDIX 2 What type of smart beta strategies are you using? U.S. Canada UK Europe (ex UK) Low volatility 33% 100% 33% 77% Fundamental 67% 17% 60% 23% High quality 17% 33% 7% 23% Maximum diversification 8% 33% 0% 31% Risk parity 17% 17% 13% 8% Momentum 25% 0% 7% 8% Equal weight 0% 17% 20% 8% Stability (defensive / dynamic) 17% 0% 13% 0% High dividend 0% 17% 13% 8% Other 17% 17% 13% 23% Multi-pick. Segment = Have smart beta allocation RUSSELL INDEXES SMART BETA: ASSET OWNER IMPLEMENTATION STRATEGIES

9 IMPORTANT INFORMATION Russell Investments is a Washington, USA corporation which operates through subsidiaries worldwide and is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Investments is the owner of the trademarks, service marks and copyrights related to its respective indexes. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. Copyright Russell Investments All rights reserved. First use: December CORP

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