smart beta A SMARTER WAY TO BUY THE MARKET

Transcription

1 A SMARTER WAY TO BUY THE MARKET smart beta FOR PROFESSIONAL CLIENTS ONLY This document is for the exclusive use of investors acting on their own account and categorized either as eligible counterparties or professional clients within the meaning of Markets in Financial Instruments Directive 2004/39/EC. It is not directed at retail clients. In Switzerland, it is directed exclusively at qualified investors

2 Introduction The age-old debate of active versus passive has occupied the minds of investors for many years. However, with the rise of Smart Beta, investors can now get the best of both worlds: the low cost, transparent and systematic nature of passive investing, and the strategic stock selection principles of an active fund. The dawn of Tracking 2.0 The growing popularity of passive investing has been driven by the desire to reduce cost, and improve transparency within a portfolio. With access to everything from developed to emerging markets; from bonds, to higher risk equities or commodities, investors of all types, sizes and risk appetites are using passives as part of a diversified portfolio. However, for some investors, simply buying the market is not enough. They don t want to track the market passively, they want to outperform it, or exploit a particular nuance or inefficiency. Traditionally this has been the domain of the active fund manager who seeks to deliver additional performance through their strategic selection skills. Smart Beta has emerged as a genuine alternative to both. It is founded on Passive investing Efficient market exposure Smart Beta Rules-based strategic exposure the principles of passive management but adds an additional, more strategic approach to stock selection. By being more selective about the stocks that are included, and how they are weighted in the portfolio, Smart Beta helps investors to target a specific risk profile or objective. Active management Strategic exposure 2<<

3 What do we mean by Smart Beta? In investment terms, beta is simply the return generated by the market: broadly, if for example the Euro Stoxx 50 goes up by 10%, then a pure beta tracker would be expected to go up by 10% too. Alpha, in contrast, is used to describe any returns above that market level, generated by an active manager s skill. Many academic studies, however, have established that much of this alpha is in fact attributable to specific factors or strategies. A straightforward example would be buying only the stocks with the strongest balance sheets in the market, which have historically outperformed companies in more precarious financial positions. Smart Beta approaches can capture these factors without the cost of an active manager. Historically, Smart Beta products have only been accessible to major institutional investors, such as giant pension funds or exclusive private banks, which can allocate large amounts of money. In recent years, however, Smart Beta exchange traded funds have been developed and launched for investors with much more modest portfolios. Total assets under management in European Smart Beta ETFs hit 15.1 Performance Performance Above Beta: Alpha Time Alpha Beta >>3

4 billion ( 11.5 billion) at the end of 2015, with 4.1 billion ( 3.1 billion) of net new assets in 2014 alone, an increase of 49% from their level a year earlier 1. This guide will introduce Smart Beta and explain the role it can play in a portfolio. It will set out the advantages of Smart Beta, and describe how and why it works as an investment approach. It will also address how Smart Beta ETFs can be used to meet a specific objective. These objectives include the reduction of risk, the increase of diversification, the enhancement of returns and the improvement of income generation. contents Chapter 1: The keys to smart beta 5 Chapter 2: ENHANCING RETURNS 9 Chapter 3: reducing risk 14 CHAPTER 4: IMPROVING DIVERSIFICATION 18 CHAPTER 5: TARGETING INCOME 21 CHAPTER 6: WHY USE LYXOR? 25 Total Income 1 Source: Lyxor Asset Management, Smart Beta Barometer December 2015 Reduce Risk Objective Enhance Returns Increase Diversifiication 4<<

5 The keys to smart beta >>5

6 Why choose smart beta? Buying a simple index tracker has long been an easy way to invest, and over the long term, trackers have tended to perform well. However, there will always be times when the market as a whole is weak. This is often attributable to specific sectors and industries. Take, for example, the rout of the energy sector, which was driven by plummeting oil prices. Investors who avoided the sector would have outperformed significantly, but those owning only traditional passive trackers could not do so, just as in 2008 when they would have been holding all the banks. Those who do not wish to buy the entire market have instead tended to opt for actively managed funds. An astute manager may not have predicted the oil crash, but could at least have recognised it early and exited the sector. The trouble is that, historically, few Even the minority of managers who have generated alpha in the past cannot be relied upon to do so again in the future. According to data firm S&P Dow Jones Indices, of 678 equity funds that were in their sector s top quartile for their performance in the year to September 2013, only 4.3% managed to stay in that top quartile by the end of September 2015 (Source: S&P Persistence Scorecard, January 2016) 80.5% of active funds have underperformed their benchmark over the past 10 years 2. active managers have demonstrated an ability to beat the market in making such calls. Over the past five years, an average of 77% of active funds underperformed their benchmark; over the past 10 years a full market cycle 80.5% lagged their index 2. 2 Source: Lyxor, Market & Research Active Funds vs Benchmark: Performance Comparison, 26 November <<

7 Even the minority of managers who have generated alpha in the past cannot be relied upon to do so again in the future. According to data firm S&P Dow Jones Indices, of 678 equity funds that were in their sector s top quartile for their performance in the year to September 2013, only 4.3% managed to stay in that top quartile by the end of September In part, active managers underperformance is due to the higher costs of their funds, which drag down returns. Whereas an active fund will charge around 1% a year in fees, passive funds can cost around %. But active funds can also lag their index because it is simply very hard for anyone to predict accurately where the market will go. Many managers, for example, thought oil stocks would recover quickly. After all, fund managers are only human and can misinterpret information or make poor decisions. Weighting strategies Smart Beta Rules-based selection Smart Beta tries to replicate strategies like those that have historically worked for active managers and completely new ones, but implement them in a more systematic and cost-efficient manner. How does smart beta work? Smart Beta funds, like other passive products, in essence track an index of underlying securities, whether these are equities, bonds or commodities. Where these indices are smart, however, is in the way that they construct their portfolio. Traditional passive funds own their securities in proportion to their size in the index: the bigger the company or the amount of bonds issued, the greater the weight in the portfolio. The FTSE 100 index, for example, consists of the 100 largest businesses listed in the UK. The largest of them is currently HSBC, and it takes up 6.5% of the entire index 4. Smart Beta funds, in contrast, build their indices according to different sets of rules. A very basic one would be that each constituent has an equal weighting. In an equally weighted FTSE 100 fund, HSBC would be just a 1% position. This limits the risk that large individual stocks can skew the performance of the entire fund. There are many other ways to construct a Smart Beta index, of course. 3 Source: S&P Persistence Scorecard, January Source: FTSE International Limited. Data as of February, >>7

8 These typically weight the index in line with rules, which can be based upon a proven active strategy, or a completely new strategy that has not been considered before. Examples of such strategies, explored more fully in the next chapter, include investing only in the highest-quality companies, the cheapest companies, or the least volatile ones. The real difference with Smart Beta is how that strategy is delivered. It is not at the discretion of an asset manager, but in adherence to a set of rules, which are clearly stated and based on verifiable financial metrics. A value strategy, for instance, would only buy stocks trading below a certain price-toearnings or price-to-book ratio. Equally, it would always sell those stocks once they rose above that ratio, whereas an active manager may cling on to them. Once these systematic rules are created, they are always followed. This means investors always know what their Smart Beta fund is doing: they do not drift in style, unlike active managers who can stray from their core competency or mandate. Following these rules also saves money, as funds do not incur the expenses of intensively researching stocks on an ongoing basis. Using smart beta in a portfolio Smart Beta does not guarantee that any strategy under its umbrella will always beat the market. But it does have a lot to offer investors who use it within their portfolios. Most importantly, it allows investors to express specific views on the market in a direct and efficient manner. If the investor wishes to own less volatile stocks, a Smart Beta fund that follows risk-based rules will do so. A passive fund that tracks the whole of the market will own the more volatile stocks too, while an active manager could decide against buying certain more stable shares. Smart Beta ETFs also allow investors to express these views according to time horizons of their own choosing. ETFs are traded throughout the day, not once a day like mutual funds, so investors can use Smart Beta ETFs to implement and close tactical positions very quickly. An investor expecting a strong but brief general equity rally following an economic data release, for example, could buy an ETF weighted to favour small cap or momentum stocks in the market an hour before the announcement and sell the ETF an hour later. But using Smart Beta to boost returns only touches the surface of what such products can bring to a portfolio. The next chapter sets out how Smart Beta can meet many other investor objectives. 8<<

9 ENHANCING RETURNS >>9

10 Using smart beta to enhance returns As discussed, Smart Beta can be designed specifically with the aim of enhancing investors returns. The advent of factor ETFs means that investors can replicate the strategies long used by active managers and supported by decades of academic evidence at a much lower cost. Research across many equity markets and over many time periods has identified five main factors that have demonstrably added genuine alpha. By isolating these specific factors from within an equity universe like the MSCI Europe index, investors can potentially outperform the general The real source of alpha Outperformance Alpha Stock selection Other drivers Real alpha Factors Low size Value Quality Low Beta Momentum The market return Beta Beta Modern investors understand that most alpha is generated by certain factors, which can be systematically reproduced in rules-based strategies. Real alpha is much rarer and often comes from identifying stock-specific risks. 10<<

11 market return (see table below). When building an index based on these factors, each stock in the original broad market index is ranked according to the extent to which it exhibits the given factor. These rankings are then reviewed in order to remove any sector bias. Following any removals, the top 10% of highest-ranking stocks are selected and each stock is weighted equally in the portfolio. By selecting only the top ranking stocks, Lyxor can provide higher SINGLE FACTOR SELECTION Starting universe MSCI Europe Index universe of 440 stocks Factor Theory Calculated By Value Cheap stocks outperform expensive stocks over time Price-to-earnings ratio, price-to-book ratio, etc Size Small stocks outperform large stocks over time Market capitalisation Quality Stocks with strong balance sheets, growing profits, etc, outperform indebted, unprofitable stocks over time Return on equity, profit margin, equity-to-debt ratio, etc stock selection Stocks ranked by factor score Reviewed for sector bias 40 stocks selected Low Beta Momentum Stocks with low leverage to the market outperform over time Stocks whose share prices have consistently risen for a given period of time are likely to keep rising Beta relative to the index Returns over specified past period re-balance Re-balanced monthly Equal stock weighting >>11

12 exposure to that factor. The indices are rebalanced every month according to the latest data. Does it work? You can see from the chart below the additional performance that can be gained by adding a tactical position using factors. In this case we look at the momentum factor which implies the selection of stocks according to their 12-month total return. The objective is to capture the trend of the market by investing in stocks, which are rising fastest. The table on page 13 highlights two important points for anyone considering adding factors to their portfolio. First, factors have consistently outperformed the Index performance of Momentum indices MSCI Europe Momentum Net TR MSCI Europe Net TR JP Morgan Europe Momentum Source: J.P. Morgan. Past performance is no guarantee of future performance. Performance figures relate to the period from January 1st, 2000 to November 30th, Performance figures are inclusive of rebalancing adjustment factor of 0.04% but gross of any running fee. 12<<

13 traditional MSCI Europe index over the long term, and secondly, the relative performance of each factor varies over time, and the successful implementation of factor ETFs is dependent on timing. For investors not wishing to make these allocations themselves, multi factor ETFs provide an equally weighted exposure to all five factors, allowing you to capture their combined performance in one single ETF. Due to the low levels of correlation between each factor, a multi factor ETF can also provide additional diversification in comparison with the traditional market cap weighted index. A summary of performance for all factors Ticker 1Y Return 1Y Sharpe Value JPERPLVA -1.50% % 10.80% 28.40% 18.70% % 7.30% Low Size JPERPLSI 16.10% % 11.50% 13.90% 10.70% % 19.20% Momentum JPERPLMO 12.30% % 5.20% 29.80% 24.00% -9.10% 22.20% Quality JPERPLQU 16.10% % 8.60% 21.00% 24.00% -3.20% 25.30% Low Beta JPERPLBE 15.7% % 8.10% 17.00% 15.80% (2.20%) 17.90% MSCI Europe Net TR MSDEE15N 8.20% % 6.80% 19.80% 16.10% -7.10% 11.10% Source: J.P. Morgan. Past performance is no guarantee of future performance. Performance figures relate to the period Jan to November Performance figures are inclusive of rebalancing adjustment factor of 0.04% but gross of any running fee. >>13

14 Reducing Risk 14<<

15 Using smart beta to reduce risk Beyond simply enhancing returns, Smart Beta products can also be used to reduce risk in a portfolio. This does not mean that they eliminate the possibility of loss. Rather, they are designed to reduce volatility and so smooth a portfolio s returns. The important thing is doing this without deviating too much from the wider market, so investors can avoid concentration risk from too few stocks. There are several ways of creating an index with lower volatility. One is simply to hold only the least volatile stocks in the market. This can work for long periods of time, but it has tended to bias portfolios towards certain sectors, such as utilities. Again, that creates unintended risks. An alternative methodology is known as minimum variance. Instead of taking only individual stocks volatility STOCK SELECTION PROCESS Starting universe FTSE All World Index stock selection Daily volatility of each stock Correlation between stocks diversification Maximum stock weights Maximum industry weights Minimum holdings >>15

16 into account, it factors in correlations between stocks. This helps to reduce the overall volatility of the portfolio, focusing on total risk management rather than just individual stock volatility. Lyxor uses the FTSE Minimum Variance index series to create such funds, with this process having demonstrably cut portfolio volatility by 20-30%. As well as selecting the historically least volatile stocks in the market and minimising their correlation Excess returns vs market CAP: SMOOTHER OUTPERFORMANCE FTSE Developed Europe Minimum Variance excess return over FTSE Europe MSCI Europe Minimum Volatility excess return over MSCI Europe Stoxx Europe 600 Minimum Variance excess return over Stoxx Europe % 40% 30% 20% 10% 0% -10% Source: Lyxor Research. Data from 30/12/05 to 30/12/15. Past performance is not a reliable indicator of future returns 16<<

17 30/12/ /12/2015 FTSE Developed Europe MSCI Europe STOXX 600 Europe Market cap Min var Market cap Min var* Market cap Min var Annualised return 4.99% 7.78% 4.21% 7.12% 5.24% 7.94% Annualised volatility 20.20% 14.93% 20.04% 15.25% 20.23% 14.48% Volatility reduction % % % Sharpe ratio Worst month % % % -9.14% % % Number of stocks as at December % of original universe % % % Source: Lyxor/ Bloomberg. Data from 30/09/05 to 30/09/15. Past performance is not a reliable indicator of future performance. to each other, the methodology caps any individual sector s maximum weighting at 20% to reduce biases. The major difference with the FTSE strategy is the diversification target, which seeks to maintain approximately 60% of the original broad market index. This is considerably more than other minimumvariance approaches where as little as 30% of the original index universe can be maintained. The result for Lyxor is that risk is spread more broadly across a wider selection of stocks. Does it work? The table above shows how European minimum-variance products have consistently minimised volatility while also enhancing returns. Diversified minimum variance ETFs are also available on US, all world and emerging market equities. >>17

18 IMPROVing DIVERSIFICATION 18<<

19 Using smart beta to improve diversification Active managers naturally create portfolios to reflect their sector and stock biases that is what they are paid to do. But passive funds also contain biases to certain sectors and stocks namely, the largest ones. Traditional market cap indices weight each component according to the size of the underlying constituents, meaning investors in them are most exposed to the largest sectors and companies. For the MSCI Europe index, that means financials (22.6% of the index) and Nestlé (3% of the index). It also means less exposure to smaller companies 5. In fact, approximately 20% of the stocks of a traditional index can make up 60-70% of the risk. 5 Source: MSCI, as of 31 December Source: Lyxor International Asset Management. A Smart Beta methodology known as equal risk contribution creates a more diversified portfolio. It owns all the same stocks as the broader index, but in proportions that spread risk more evenly between them rather than concentrating risk in the largest stocks. The process achieves this by weighting stocks according to their volatility and correlation, instead of their size, but with every stock still represented. The least volatile stocks are the largest in the portfolio, although exposure to them is still small by market-cap standards. The largest position in the MSCI Europe Equal Risk Contribution (ERC) index, for example, has a 1.5% weight 5. This creates a portfolio with a neutral risk balance: it is exposed equally not to each stock, but to each stock s risk. Historically, this approach has increased exposure to smaller companies and boosted total returns by 2-3.5% whilst remaining consistent with the original benchmark index 6. It has also been seen to reduce portfolio volatility by 8-10% compared with market-cap weighted indices. Does it work? The table below shows how the MSCI Europe ERC index has outperformed the MSCI Europe index in recent years. net returns 1 year 5 year 10 year MSCI Europe ERC Index -9.96% 7.21% 3.75% MSCI Europe Index % 5.61% 2.77% Sources: MSCI Inc. Data as of 29/02/16. Past performance is not a reliable indicator of future returns. >>19

20 STOCK weighting PROCESS Starting universe All stocks of the original market cap weighted index observations Daily price volatility Stock correlations weighting According to volatility and correlation Re-weighted semi-annually Index performance of MSCI Europe ERC vs MSCI Europe Market Cap ERC Market Cap Source: Lyxor International Asset Management. Past performance is not a reliable indicator of future performance. 20<<

21 TARGETING INCOME >>21

22 Using smart beta to target income With interest rates and bond yields remaining exceptionally low by historic standards around the world, many investors who need to generate income have turned to equities. However, equities are more volatile than bonds and there are fewer guarantees with dividends than with bond coupon payments. Furthermore, investors chasing equity yields can be forced into undesirable sectors and companies with unsustainable dividends. Income stalwarts, like banks before the 2008 crash, or the energy majors before the price of oil plummeted, can suddenly become imperilled. Index performance of SGQE MSCI Europe Minimum Volatility (in EUR) MSCI Europe High Yield (in EUR) MSCI Europe (in EUR) SG European Quality Income Index Source: Lyxor International Asset Management. Data as of 09/04/02 to 29/01/16. Past performance is not a reliable indicator of future performance. 22<<

23 Smart Beta can provide a better way of capturing equity income, which can be an essential part of long term performance. The Société Générale Global Quality Income index series, for example, has been designed to focus on high but sustainable yields. Developed over 10 years, the selection process begins with 3,000 highly liquid non-financial stocks. The methodology then filters out those companies with low profitability, with low operating efficiency, and with high leverage. It then excludes the 60% of the remaining stocks with the weakest balance sheets, and finally incorporates only those with a dividend yield of at least 4%. This creates a portfolio STOCK SELECTION PROCESS Starting universe Developed world equities excluding financials (global or European) stock selection 9-point quality assesment Balance sheet strength test Dividend yield above 4% re-balance Re-balanced quarterly Equal stock weighting >>23

24 Total Return (%) Yield (%) Annualised Volatility (%) Maximum Loss (%) 1 Year 10 Year 1 Year 10 Year 1 Year 10 Year 1 Year 10 Year SGQE MSCI Europe MSCI Europe High Yield MSCI Europe Min Vol Source: SG Cross Asset Research\Equity Quant, Bloomberg * Performance shown prior to May 15, 2012 is a back-test. Performance does not include transaction costs. Past performance is not indicative of future performance of between 25 and 75 high-quality companies paying a high but sustainable dividend. Does it work? As the table above shows, the Société Générale European Quality Income index has achieved a higher dividend yield than the MSCI Europe High Dividend Yield index over the past 10-year period, while also minimising risk by holding higher-quality stocks. For example, the maximum drawdown of the Société Générale European Quality Income index has been lower than that of the MSCI Europe Minimum Volatility index over both the past 10 years and is practically the same over 1 year. Quality Income strategies are available on European or global equities, and can distribute or accumulate income. 24<<

25 why use lyxor? >>25

26 Lyxor has been a pioneer in the ETF market since 2001, when we launched our first ETF. Today, the group ranks amongst the top ETF providers in the world: we are number three in Europe and number seven in the world by assets under management. We are number two for liquidity in Europe with 20% of ETF trading and we are supported by a network of 45 authorised participants and 19 market makers. Lyxor has also pioneered the development of Smart Beta, and now ranks number three in Europe for Smart Beta ETF assets. Since launching our first portfolios tracking Smart Beta indices in 2007, Lyxor has continuously invested in Smart Beta research, with a focus on risk-based portfolio construction, equal risk contribution, factor investing and other quantitative investment areas. Lyxor employs portfolio managers who specialise in dealing with the specific trading constraints of Smart Beta ETFs, and provides direct access to the authors of the original models underpinning our index-construction methodologies. Lyxor also embraces open architecture, with the creation of our own proprietary Smart Beta strategies 49bn Assets Under Management 236 ETFs listed on 13 exchanges globally 3 rd Largest ETF provider in Europe by Aum 2001: The year we launched our first ETF Source: Lyxor International Asset Management. Data as of March anchored on findings and publications from Lyxor Research since 2009 as well as the third-party strategies we have carefully selected. Lyxor maintained its commitment to the utmost quality in 2011 by formalising this commitment with the Lyxor ETF quality charter, which set new quality standards across four main areas. 26<<

27 To find out more visit Risk Warning It is important for potential investors to evaluate the risks described below and in the fund prospectus which can be found on CAPITAL AT RISK: ETFs are tracking instruments: Their risk profile is similar to a direct investment in the Underlying Index. Investors capital is fully at risk and investors may not get back the amount originally invested. REPLICATION RISK: The fund objectives might not be reached due to unexpected events on the underlying markets which will impact the index calculation and the efficient fund replication. COUNTERPARTY RISK: Investors are exposed to risks resulting from the use of an OTC Swap with Societe Generale. In-line with UCITS guidelines, the exposure to Societe Generale cannot exceed 10% of the total fund assets. Physically replicated ETFs may have counterparty risk resulting from the use of a Securities Lending Programme. UNDERLYING RISK: The Underlying Index of a Lyxor ETF may be complex and volatile. When investing in commodities, the Underlying Index is calculated with reference to commodity futures contracts exposing the investor to a liquidity risk linked to costs such as cost of carry and transportation. ETFs exposed to Emerging Markets carry a greater risk of potential loss than investment in Developed Markets as they are exposed to a wide range of unpredictable Emerging Market risks. CURRENCY RISK: ETFs may be exposed to currency risk if the ETF is denominated in a currency different to that of the Underlying Index they are tracking. This means that exchange rate fluctuations could have a negative or positive effect on returns. LIQUIDITY RISK: Liquidity is provided by registered market-makers on the respective stock exchange where the ETF is listed, including Societe Generale. On exchange liquidity may be limited as a result of a suspension in the underlying market represented by the Underlying Index tracked by the ETF; a failure in the systems of one of the relevant stock exchanges, Societe Generale or other market-maker systems; or an abnormal trading situation or event. Photographs by istock, Shutterstock, Image: Alamy >>27

28 In accordance with MiFID as implemented in France and applicable to Lyxor International Asset Management, this publication should be treated as a marketing communication providing general investment recommendations. This document has not been prepared in accordance with regulatory provisions designed to promote the independence of investment research. This document is for the exclusive use of investors acting on their own account and categorized either as eligible counterparties or professional clients within the meaning of Markets in Financial Instruments Directive 2004/39/EC. It is not directed at retail clients. In Switzerland, it is directed exclusively at qualified investors. smart beta This document is of a commercial nature. It is each investor s responsibility to ascertain that they are authorised to subscribe, or invest into this product. Prior to investing in the product, investors should seek independent financial, tax, accounting and legal advice. 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