Just the factors: making sense of smart beta strategies By Alex G. Piré, CFA Indexed Smart Beta vs. Actively Implemented Smart Beta Smart beta 1 can be considered one of the most confusing investment terms in the market. Generally speaking, smart beta strategies seek to exploit market anomalies and/or risk factors to deliver capital appreciation, diversification, and risk management through the use of quantitative portfolio construction. However, not all smart beta strategies are built and implemented in the same manner. This whitepaper looks at smart beta strategies with an eye towards contrasting indexed smart beta and the next generation of actively implemented smart beta in order to help readers make sense of these important strategies. Not Your Father s Index: Understanding Smart Beta Strategies The Birth of Smart Beta In investing, the term index refers to a grouping of securities representing a particular segment of the securities markets. Well-known indexes such as the S&P 500 2 help provide investors and financial professionals with a sense of the health and direction of the broader economy. Given the range of available choices, the analysis that informs smart beta strategies and the way in which smart beta strategies are constructed and implemented is of primary importance to ensure outcomes are in line with expectations. Indexes were initially constructed using simple objective measures to dictate the weight of individual securities. Such measures include the market price of a security or its market capitalization. Over time, index providers began to introduce alternatively weighted indexes. These included equal-weight indexes which give the same weight or importance to company stocks regardless of company size as well as more complex indexes based on risk factors such as volatility, 3 valuation 4, dividend rates, 5 earnings, or book value. 6 It is these more complex indexes that gave way to a new trend in investing which became known as smart beta.
Gauging Traditional Indexes: Too Much Sameness? As a consequence of using well-established objective measures, traditional indexes often tend to have minimal leeway or flexibility in implementations, which can make them good substitutes for each other. For illustration, consider that the 5-year tracking error (or price behavior difference) between the major large-cap US equity indexes (S&P 500, Russell 1000 7 and MSCI USA 8 ) is less than 1% which demonstrates significant correlation between the various approaches (see graph). Similarly, sector indexes, or indexes that track groups of companies involved in similar businesses, tend to select the same securities in similar proportions, which can lead to them exhibiting similar investment risk and return. These similarities can cause investors and financial professionals to associate traditional indexes with commoditized products which provide exposure to a given market segment with little differentiation between providers. Getting Smart About Smart Beta Because of the potential for high correlation between traditional indexes, it s hard to fault those who have followed in the tradition of an index is an index is an index as alternative indexes and smart beta strategies evolved. Yet it is possible that many investors and financial professionals have failed to consider that smart beta strategies are in fact quite different. Indeed, unlike traditional indexes, smart beta indexes tend to be constructed using proprietary definitions, rules, and construction methodology, which can result in significant differences within a given smart beta segment. For example, consider that the 5-year tracking error between traditional large-cap US indexes and low volatility indexes ranges from 4% to 6%. That range is similar to the 5-year tracking error between the various low volatility indexes (3% 5%). These ranges may suggest that various low volatility indexes are almost as different from each other as they are from their traditional index counterparts. Putting the Smart in Smart Beta Given the range of available investment choices, the analysis that informs smart beta strategies and the way in which smart beta strategies are constructed and implemented is of primary importance to ensure expected outcomes are in line with expectations. The decisions taken to go from Point A to Point B, or from a theoretical factor to a factor-based strategy, have the potential to lead to significantly different portfolios and outcomes. Investors and financial professionals should therefore be cautious of smart beta indexes and their associated strategies, and approach these investments with the same level of care they would apply to any other portfolio management decision. 5-year tracking errors between indexes 7% 6% 5% 4% 3% 2% 1% 0% Difference among cap-weighted indexes Difference between cap-weighted and low-vol indexes Source: Bloomberg, Seeyond; data from June 30, 2012 to June 30, 2017 Indicies: S&P 500, Russell 1000, MSCI USA Past performance is no guarantee of, and not necessarily indicative of future results. Difference among low-vol indexes Comparing Different Kinds of Smart Beta One of the most common misconceptions regarding smart beta investing strategies is that all smart beta approaches are equivalent. We believe many financial professionals assume that all factor strategies 9- are created equal likening various factor-based investment strategies to the cap-weighted index world, where index components are weighted according to the total market value of their outstanding shares. 2
However, traditional (market cap-weighted) indexes can exhibit low tracking error 10 and high correlation to each other. This is due mainly to the fact that their weighting scheme is based on a well-established objective measure and very little leeway exists in defining and implementing these indexes. On the other end, there are no objective measures and definitions for most smart beta strategies, which in turn tend to exhibit characteristics more akin to actively managed 11 strategies, as each provider is free to make choices that define their own investment approach. Take low volatility for example. Low volatility investment strategies, sometimes referred to as managed volatility or minimum variance strategies, attempt to deliver equity market returns with less return variability than an index. A variety of players have developed products that seek to take advantage of the low volatility anomaly inherent to global equity markets. However, each provider has a different definition of volatility, and which metrics they use to define the factor. Standard deviation is often the metric of choice but approaches can vary in terms of the past period being evaluated, ranging anywhere from 3 months to much longer periods (e.g. 5 years). In addition, some low volatility approaches incorporate correlations a statistical measure of how two securities move in relation to each other while others follow a simpler approach. What s more, implementation can also vary widely. Some strategies choose to focus on the lowest volatility securities in the universe, adopting a simplistic weighting scheme (i.e. equal weight 12 ), while others use more complex optimization techniques to enhance diversification or isolate unintended exposures. Finally, the majority of low volatility approaches currently available in the US fall into the traditional indexed approach and seek to tilt a headline index towards the low volatility factor, while focusing implementation on minimizing turnover and trading cost. More recently, active asset managers have introduced strategies that take an active implementation approach and build risk-focused low volatility strategies from the ground up which seek to yield better investment outcomes for investors (i.e. provide more consistent, lower volatility while seeking capital appreciation). Given that all low volatility strategies are not created equal, the decision to choose one approach versus another is of primary importance when considering the range of available smart beta strategies. Indeed, unlike in the cap-weighted space, going passive 13 does not take manager risk away in the world of smart beta, as the index providers definition and methodology is in essence an active choice. It follows that unlike traditional index strategies, cost may no longer be the sole primary concern when purchasing a smart beta product. Evaluating individual strategies, understanding their benefits and drawbacks, and getting a clear picture of their actual investment outcome are fundamentally important. A good analogy may be to compare traditional indexing with gasoline. Gas is gas, and while finding the lowest price gas for one s car is pragmatic, it s not necessarily essential. On the other end, when selecting a smart beta low volatility investment strategy, investors and financial professionals could benefit from taking an approach similar to shopping for a new automobile. They 3
can seek to understand the benefits and drawbacks, features, and characteristics of each investment vehicle before making a decision, because investment vehicles and automobiles both have features which may not be substitutable and they should be sure they are gaining access to the features that are most important to them. The Hidden Risks of Smart Beta Indexing The concept of manager risk is seldom considered when talking about passive indexing, or investment strategies that track a market-weighted index. However, it is of primary importance when considering smart beta indexes. Indeed, passive implementation based on smart beta indexes from well-known providers can still be exposed to the same manager risk as active strategies. In this case, the index provider or a third party partner defines the strategy and builds the methodology. This is not dissimilar to quantitative managers who actively define, build and manage portfolios (which are in essence proprietary indexes), with the important distinction that active managers have the potential to benefit from the flexibility of leeway in implementation and trading. Therefore, it is important to evaluate and understand the hidden risks of following a passively implemented smart beta index. Passive smart beta strategies can typically offer investors lower fees while still providing exposure to common risk factors. However, due to their passive nature, smart beta indexes tend to exhibit significant constraints. It is typical for providers to apply diversification constraints at the sector, country, and position levels, which can force these strategies to hold suboptimal allocations. In fact, many providers apply these constraints relative to a market cap-weighted index, which can yield portfolios that are overweight to unwanted market segments. It is therefore typical for such indexes to feature an erosion of the factor they seek to exploit, as the final index will tend to have high correlation to its cap-weighted parent. These products can typically be thought of as tilted towards a factor rather than a true factor strategy. Index providers have an incentive to prioritize minimizing implementation cost over investment outcomes. By following an index with a quarterly or semi-annual rebalancing frequency, investors can expose themselves to a portfolio that, in between rebalances, may no longer reflect the factor and outcome it had initially sought. A strong focus on low costs can be reflected throughout the supply chain from the early development (which typically yields similarity to the parent index) to implementation, where a premium can be placed on low turnover and less frequent rebalancing aimed at lowering overall transaction costs. Such constraints can have unintended effects on smart beta indexes. Unlike traditional indexes based on market segments such as market cap, geography, and sectors, securities that display the characteristics of a given smart beta factor such as company size, value, and volatility tend to incur more change over time. Whereas a security s market cap, geography, or sector classification is relatively static, its exposure to a given factor is prone to change more frequently. As a result, some passive indexing investment strategies may not be in line with their stated outcome at a given time. An additional effect of a low turnover constraint and a sparse rebalancing schedule is the concept of path dependency. Put another way, if a given portfolio can only turn over within rigid constraints, the manager might never be able to truly shift the allocation to an optimal basket of securities in their effort to fulfill their stated investment objective. 4
Take for example the case of a low volatility 14 portfolio with semi-annual rebalancing and a maximum allowable rebalancing turnover of 30% per annum. In an evolving market where the profile of those securities that make up the current portfolio has shifted from low volatility to high volatility, the portfolio will only be able to trade (turn over) about a third of the portfolio every year. The portfolio then runs the risk of constantly playing catch-up while attempting to remove the unwanted exposure, ultimately yielding a sub-optimal expression of the low volatility factor. It is important to understand that index providers typically prioritize lower overall implementation cost over a given investment outcome. Although this can lead to low fees, it can also lead to unwanted investment outcomes which have the potential to introduce a significant amount of risk and uncertainty into a portfolio. While actively managed smart beta approaches also involve risks and often charge investors a higher price point, they can help resolve these issues through a higher frequency of rebalancing and daily portfolio monitoring. Moreover, unlike passive investments, active investments do not track or replicate an index. Thus, the ability of the investment to achieve its objectives will depend on the effectiveness of the portfolio manager. 15 Going Active: A Dynamic Approach to Smart Beta While smart beta is often viewed through a passive investment lens and applied to style or factor investing, similar strategies that pre-date global investment consulting firm Towers Watson s coining of the term smart beta were often implemented in an active fashion. Examples of such strategies date back to the first half of the 1900s starting with Benjamin Graham and David Dodd s Security Analysis (1934), which popularized the value factor. 16 We find further evidence of factor investing evolutions through Bill Sharpe (1964), Robert Haugen (low volatility, 1972), and most recently Fama/French (1992) or Carhart (1997). Considering the Tech Factor What s really new with smart beta strategies is the technological revolution behind them: Easier data access and advanced computer capabilities bring enhanced discipline to investment processes, as well as a wider scope of potential applications. The advance of smart beta indexing has helped popularize quantitative factor investing 17 by making it more accessible to investors. But the process of indexation 18 has also led in some cases to the introduction of various risks which have the potential to erode the value investors can derive from such strategies. At its core, the primary goal of indexation is to provide the most cost-effective exposure to a market segment. This approach has proven adequate for providing market exposure in the traditional sense using market-capitalization 19 or price-weighted 20 approaches, as these measures are objective and widely accepted. However, passive smart beta strategies vary widely in definition, approach and implementation, which in turn leads to a wide variation in resulting portfolios and outcomes. In addition, risk factors may not benefit from the stability of a market capitalization, country, or sector classification. This can create a need to rebalance when the market structure changes and might not fit well within a bi-annual, turnover-constrained passive framework. Finally, in order to attempt to exploit a market anomaly or risk factor, a strategy needs to be thoughtfully constrained in a manner that does not erode its value. Some investment companies have developed actively implemented quantitative strategies that seek to overcome the hurdles of purely passive smart beta in the attempt to provide a purer exposure to factors such as volatility. While fully embracing the benefits of discipline and breadth brought by a systematic approach, these solutions can introduce portfolio manager oversight where the investment team believes it can add value: active oversight and implementation. Going active with factors can take different forms from a more traditional fundamental strategy to a quantitative approach. Although each approach has its potential advantages and disadvantages, investors may benefit from the full attention of portfolio managers who are providing consistent monitoring of the portfolio in an attempt to see a strategy take advantage of the given factor/anomaly as effectively as possible. Unlike passive implementations, these strategies have the potential to quickly react to evolving market conditions and shift the burden back to the manager in an attempt to keep the portfolio representative of the stated investment objective. This constant monitoring and, when needed, re-adjusting of the portfolio can yield higher turnover and transaction expenses and is at the heart of active implementation: seeking the right tradeoff between implementation cost and investment outcome. Overall, the key is to consider that any strategy you are considering for your portfolio follows a sound investment thesis, a robust investment process, and the potential to provide consistent investment outcomes in line with the stated objective. Passive smart beta does not take manager risk away. Whether passive or active, robust investment due diligence remains important and should at least include the 3 Ps: People, Philosophy and Process. 5
Alex G. Piré, CFA Head of Client Portfolio Management, Seeyond Alex Piré is a Vice President of Natixis Asset Management U.S. and Head of Client Portfolio Management for Seeyond in the US. In this role, Mr. Piré is responsible for representing Seeyond s active quantitative investment strategies, supporting client relationships and serving as a thought leader on factor investing. He also serves as a resource to intermediary and institutional investors, providing insights into global equity markets and asset allocation. Mr. Piré joined Natixis from his most recent position as acting head of product at Jennison Associates, where he led the development and management of Jennison s actively managed fundamental and quantitative equity strategies. Prior to joining Jennison, Mr. Piré served as a director within the Equity Investment Product division at Fidelity Investments. He began his career as a principal at State Street Global Advisors serving as portfolio specialist for their Equity Beta Solutions team. Mr. Piré holds a Bachelor of Arts in economics and business administration from Boston University and is a CFA charterholder. Seeyond is operated in the US through Natixis Asset Management U.S., LLC. Footnotes: 1 Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. Smart beta strategies involve risk, including risk of loss. 2 The S&P (Standard & Poor s) 500 Index is an index of 500 stocks often used to represent the US stock market. 3 Volatility refers to the range of variation in the value of a security. 4 Valuation can be defined as the process of determining the current worth of an asset or company. 5 A dividend rate is the total amount of expected dividend payments from an investment. Dividend rates can be fixed or adjustable, depending on a particular company s preferences and strategy. 6 Book value refers to the total amount a company would be worth if it liquidated all its assets and paid back all its liabilities. 7 The Russell 1000 Index is an index of approximately 1,000 of the largest companies in the US equity markets. It is a subset of the Russell 3000 Index. 8 The MSCI USA Index includes 637 companies and measures the performance of large and mid-cap segments of the US market. 9 Factor investing is an investing strategy in which securities are chosen based on attributes that are associated with potentially higher returns. 10 The term tracking error, sometimes called active risk, refers to the difference between a portfolio s returns and the benchmark or index it was meant to mimic or beat. 11 Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. 12 Equal weight is a type of weighting that gives the same importance to each stock in a portfolio or index fund. 13 Passive Management: Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. 6
14 The term low volatility refers to limited fluctuation of value over time. By contrast, high volatility refers to dramatic fluctuation of value over time. 15 There is no assurance that the investment process will consistently lead to successful investing. 16 A value factor is any characteristic that can help explain the risk and return of a group of securities. 17 A quantitative factor is an investment outcome or potential investment outcome that is measurable in numbers or numeric terms. This could include costs, revenues, or non-financial data for outcomes to a decision. 18 Indexation refers to the linking of adjustments made to the value of a security to a predetermined index. 19 Market capitalization refers to the outstanding value of a company s shares. 20 A price-weighted index is an index in which each stock influences the index in proportion to its price per share. Its value is generated by adding the prices of each of the stocks in the index together and dividing them by the total number of stocks. 21 Tracking error is the difference between the return of a portfolio and the index or benchmark it attempts to replicate or beat. Diversification does not guarantee a profit or protect against a loss. It is not possible to invest directly in an index. Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted. 7
NATIXIS INVESTMENT MANAGERS Natixis Investment Managers serves financial professionals with more insightful ways to construct portfolios. Powered by the expertise of more than 20 specialized investment managers globally, we apply Active Thinking to deliver proactive solutions that help clients pursue better outcomes in all markets. Natixis ranks among the world s largest asset management firms 1 ($997.8 billion AUM 2 ). Natixis Investment Managers includes all of the investment management and distribution entities affiliated with Natixis Distribution, L.P. and Natixis Investment Managers International, LLC. 1 Cerulli Quantitative Update: Global Markets 2017 ranked Natixis Investment Managers (formerly Natixis Global Asset Management) as the 15th largest asset manager in the world based on assets under management as of December 31, 2016. 2 Net asset value as of December 31, 2017. Assets under management ( AUM ), as reported, may include notional assets, assets serviced, gross assets and other types of non-regulatory AUM. This document may contain references to third party copyrights, indexes, and trademarks, each of which is the property of its respective owner. Such owner is not affiliated with Natixis Investment Managers or any of its related or affiliated companies (collectively Natixis ) and does not sponsor, endorse or participate in the provision of any Natixis services, funds or other financial products. The index information contained herein is derived from third parties and is provided on an as is basis. The user of this information assumes the entire risk of use of this information. Each of the third party entities involved in compiling, computing or creating index information disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to such information. Natixis Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers. Natixis Distribution, L.P. is located at 888 Boylston Street, Boston, MA 02199. 800-862-4863 im.natixis.com 2026808.1.1 Exp. 2/28/2019 WP23-0218