Building portfolios with smart beta

A contentious topic! if one can find a more reliable alpha, and pay less for it, that would be pretty smart Rob Arnott When I hear smart beta, it makes me sick Bill Sharpe Smart beta: Not New, Not Beta, Still Awesome Clifford Asness what the devil are they talking about when they say smart beta? John Jack Bogle

What do we mean by smart beta? A framework to challenge the approach of only focusing on market beta and alpha: Bulk Beta Smart Beta Alpha Alpha vs beta Some alpha could be beta Bulk beta is not the only beta Beta framework Absolute risk and return: Sharpe ratio above tracking error Portfolio construction is all about position sizing Investor skill replaces some alpha skill Need to understand and monitor smart beta positions Requires beliefs and expertise Governance vs alpha more up front, less on-going (?)

What do we mean by smart beta? Ideally smart beta strategies should be: Mechanical Broad Simple Low cost Repeatable process limited discretionary management Low idiosyncratic risk Transparent as simple as possible, as complicated as necessary Reflect nature of the process With a robust investment case: Historical returns Rationale Sustainability Appropriate for the investor

How did we get here? - two perspectives Implementation focus Reduce concentration Avoid bubbles in stocks / sectors Reduce impact of index flaws Better representation Return / risk driver focus Systematic exposure to group of stocks Capture additional risk / factor premium May be economic or behavioural Improve efficiency Through better implementation By combining diverse return drivers 5

Some alpha is beta Return drivers (old and new) capture hedge fund industry returns - example using HFRI index A large % of Hedge Fund returns can be explained by a combination of equities and alternative betas Once identified, these return drivers can be captured in beta format (simple, low cost, transparent ) Cumulative excess returns Drawdown 30% global equities plus 70% combination of alternative betas 75%+ of monthly return variation explained by beta Source: Towers Watson, HFRI, FTSE, various managers 6

Benefits of new return drivers Low correlation Rolling 3 year correlation 1.0 0.8 0.6 0.4 0.2 0.0-0.2-0.4-0.6 1993 1996 1999 2002 2005 2008 2011 Equities vs Corporate Bonds Carry vs Trend Source: Towers Watson, FTSE, Merrill Lynch, various managers 7

A broader set of return drivers Complements traditional return drivers, including traditional manager skill Return drivers Term Credit Equity EM wealth Bank debt Low beta Trend Value Carry Credit basis Reinsurance Merger arbitrage Short volatility Insurance Illiquidity Skill - systematic Skill - thematic Skill - manager Skill - allocation 8

Building portfolios with return drivers A complement to the traditional asset class lens Its beta portfolio construction rules apply in return driver space as well More return driver allocation with More return Less risk, including tails More diversity (lower correlation) Return Driver Sharpe ratio Left tail multiplier Return driver target % Equity 0.25 2 23 Term 0.11 2.5 5 Inflation 0.12 2.5 4 Credit 0.24 2.5 4 Illiquidity 0.38 3.5 18 Insurance 0.42 4.5 11 Skill - systematic 0.21 3.5 6 Skill - thematic 0.14 2 6 Skill - manager 0.19 2.25 17 Skill - allocation 0.12 2.5 6 For illustration purposes only 9

Examples Equity + Skill focused, 400bps excess return Cost 120bps Asset allocation risk budget = 250bps Allocation % Equity Smart beta Skill focused Equity Active 30 Alternative betas Alternative credit 10 Hedge funds 20 Core real assets Private Markets 15 Active IG credit 25 0 10 20 30 40 Equity Term Inflation Credit Illiquidity Insurance Skill - Systematic Skill - Manager Skill Thematic Skill - Allocation Return drivers Government bonds For illustration purposes only 10

Examples Beta focused, 250bps excess return Cost 35bps Asset allocation risk budget = 0bps Allocation % Skill focused Beta focused Equity Smart beta 15 Equity Active 30 Alternative betas 25 Alternative credit 10 5 Hedge funds 20 Core real assets 15 Private Markets 15 Active IG credit 25 15 Government bonds 25 0 10 20 30 40 Equity Term Inflation Credit Illiquidity Insurance Skill - Systematic Skill - Manager Skill Thematic Skill - Allocation Return drivers For illustration purposes only 11

Some considerations Not all return drivers are equal (?) Macro consistency Confidence in alpha vs equity? Capital efficiency want to maximise return driver per unit cost Long only vs long short implementation Other Overall diversity / robustness Complexity

What useful things come from smart beta? Bulk Beta Smart Beta Alpha Improve on bulk beta Capture some returns previously labelled as alpha Reduce concentration Non-price weighting More diversifying betas Customise based on context Work Target better factors with skilled or themes active managers Cost-effective exposures Better understand true alpha Offset unwanted factor risk Improve benchmarks Smart beta: a very useful tool for asset owners!

Disclaimer Towers Watson Limited ( Towers Watson ) has prepared this report for information only. Specific professional advice should be taken before any action is taken based upon this report. This report is provided for the purpose indicated. This report is based on data available to Towers Watson at the date of the report and takes no account of subsequent developments after that date. It may not be modified or provided to any other party without Towers Watson s prior written permission. It may also not be disclosed to any other party without Towers Watson s prior written permission except as may be required by law. In the absence of our express written permission to the contrary, Towers Watson accepts no responsibility for any consequences arising from any third party relying on this report or the opinions we have expressed. This report is not intended by Towers Watson to form a basis of any decision by a third party to do or omit to do anything. The analysis in this report is based on a range of assumptions which influence the output and our recommendations. The assumptions have been derived by Towers Watson through a blend of economic theory, historical analysis and the views of investment managers. They inevitably contain an element of subjective judgement. Our opinions and return forecasts are not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by Towers Watson to any party, of the future performance of the asset classes in question, either favourable or unfavourable. Past performance should not be taken as representing any particular guide to future performance. 14