Lazard Insights Distilling the Risks of Smart Beta Paul Moghtader, CFA, Managing Director, Portfolio Manager/Analyst Summary Smart beta strategies have become increasingly popular over the past several years as investors seek efficient and low-cost access to persistent drivers of return The recent success of smart beta strategies has masked their underlying risks such as prolonged and sizable drawdowns relative to the market A multi-factor approach represents a step forward in the evolution of quantitative investing. We believe that exposure to more than one systematic driver of returns can help generate balanced return streams and solve for some of the risks posed by a smart beta strategy Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights. Smart beta strategies have gained popularity over the past decade as investors seek efficient and low-cost access to persistent drivers of return. In this paper, we define smart beta, describe its recent popularity, and detail some of the distortions that can occur due to increased asset flows. Finally, we discuss some of the ways to mitigate these risks through an active, multi-factor approach. What Is Smart Beta? There is no single, industry-wide definition of smart beta. This is reflected in the different labels smart beta strategies are given in the asset management industry and the varying design and implementation of these strategies. However, we define smart beta as a rules-based approach to portfolio construction that weights stock positions differently than a cap-weighted index in order to generate outperformance. While there are many different approaches to smart beta, each strategy offers diversification potential and looks to exploit a market anomaly, which are also called factors. Such strategies tend to employ a long-only, single factor approach within a single asset class, typically equities, and are systematically implemented and rebalanced to maintain the factor exposure. Smart beta strategies are designed to enhance the efficiency of equity portfolios by either diversifying risk or increasing an overall portfolio s return or both.
2 Smart Beta Investing Is in Vogue Four of the most popular smart beta factors are momentum, value, quality, and low volatility. Broadly, these smart beta factors have outperformed market cap weighted indices for 28 years (Exhibit 1). Therefore, it is not surprising that investors have increasingly turned to smart beta products targeting these factors. Over the last decade, there has been a sharp rise in assets invested in smart beta exchangetraded funds (Exhibit 2). However, we believe that the underlying risks of this investment approach are not fully understood. Key Risks of Smart Beta The recent success of smart beta strategies has masked their underlying risks. We believe there are six specific risks (Exhibit 3), which we have grouped under two categories: Unappreciated Cyclical Risks (time horizon risk, valuation risk, and entry point risk) and Poor Product Design Risks (risk model failure, poor specification risk, and macro association risk). Any of these risks can cause an investor to suffer sizable drawdowns relative to the market or return patterns that are different from what was expected. For a more detailed analysis of these risks, read: The Six Sins of Smart Beta. Unappreciated Cyclical Risks As discussed, four popular smart beta MSCI indices Momentum, Value, Quality, and Minimum Volatility have generated positive returns relative to the market cap weighted benchmark, the MSCI World Index, over the last several decades. However, one of the biggest risks of a smart beta strategy is a period of a prolonged drawdown and despite these having positive long-term returns on average, all of these smart beta indices have experienced extended periods where they were out of investor favor (Exhibit 4). These drawdowns can be quick or gradual, leading an investor to abandon that particular smart beta strategy. Since 1990, each of these smart beta indices have experienced a significant amount of negative performance over three-year periods a fair time frame to assess the success of a strategy versus the market cap weighted index. These negative relative returns range from 19% of the time for the MSCI World Quality Index up to a stunning 46% of the time for the MSCI Minimum Volatility Index. Furthermore, drawdowns for these smart beta indices range from eight to twelve years, meaning that it would take investors eight to twelve years to recover their underperformance if they invested at the peak. For instance, investors that allocated to the value smart beta index in July 2007 would still significantly lag the market cap weighted index today. Despite value s attractive long-term returns, many would have likely abandoned the strategy before performance recovered. We believe many investors do not fully appreciate this cyclical risk. Exhibit 1 Smart Beta Captures Market Anomalies to Drive Performance Long-Term Performance of Smart Beta (Index, 100 = 29 December 1989) 1,800 1,200 600 0 1989 MSCI World Momentum TR USD MSCI World Value Weighted TR USD MSCI World Quality TR USD MSCI World Minimum Volatility TR USD MSCI World Index TR USD 1995 2000 2006 As of 29 December The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent the performance of any product or strategy managed by Lazard. Source: Bloomberg Exhibit 2 Smart Beta Assets Have Doubled in Seven Years (% of Total Global AUM) 4.5 3.5 2.5 1.5 2010 As of 29 December Source: Bernstein Exhibit 3 Key Risks of Smart Beta Unappreciated Cyclical Risks Time Horizon Risk Valuation Risk Entry Point Risk Risk Model Failure 2012 For illustrative purposes only. Source: Lazard 2013 2014 Poor Product Design Risks Poor Specification Risk 2015 2016 Macro Association Risk
3 Exhibit 4 Single Factors Have Experienced Prolonged Drawdowns MSCI Factor Index Versus MSCI World Annualized Active Return % of 3-year periods with negative relative return MSCI World Momentum MSCI World Value Weighted MCSI World Quality MSCI World Minimum Volatility 3.30 1.13 3.96 0.83 23.60 40.70 18.90 46.80 Exhibit 5 Active Factors Can Offer Alpha (Index, 100 = 30 June 2009) 160 Lazard s Global Value Factor (Simulated) 140 120 100 MSCI World Value Weighted Index 80 2009 2013 69% Correlated 2015 Longest Drawdown Volatility Quality Value Momentum As of 31 December For illustrative purposes only. Global Value Factor performance represents the relative return from a synthetic portfolio constructed using the top 20% of securities in the Lazard Global stock universe versus the MSCI World Index. Stocks are selected using the Lazard Quantitative Equity Model proprietary quantitative sentiment. Standard deviation is used to measure volatility. There are no transaction costs included and this simulation is not representative of any portfolio managed by LAM. Simulated past performance is not a reliable indicator of future results. See the Important Information section for additional disclosures. The index is unmanaged and has no fees. One cannot invest directly in an index. Source: Lazard 1990 1993 1996 1999 2002 2005 2008 Poor Product Design Risks 2014 As of 31 July Statistics calculated using index data from December 1989 to July The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent the performance of any product or strategy managed by Lazard. Source: Lazard, Bloomberg Less expensive products are not always better and flaws are often embedded in smart beta product design. In certain smart beta strategies, transparency of implementation could expose an investor to front running and thus dampen returns, while in others the goal of portfolio construction is to achieve scale and not excess returns. A common theme among smart beta strategies is that they prize simplicity over effectiveness. For instance, the MSCI Value Index, a smart beta index, and Lazard s Global Value Factor simulation, exhibit some meaningful differences. While the returns of these two factors are correlated at close to 70%, the MSCI Value Index has yielded flat to negative returns over the past eight years, while the active value factor has delivered a more attractive return (Exhibit 5). Some simple portfolio construction techniques can also expose investors to embedded macroeconomic bets, which can drive returns. All of these issues can lead to confusion about the expected return outcomes and could ultimately impact both the risk profile and the realized returns of a strategy. The Case for a Multi-Factor Approach Prior to the creation of smart beta products, alpha was considered the excess return achieved over a market cap weighted benchmark. Today, investors definition of alpha has evolved to incorporate the risk reduction and return improvement that is possible through systematic factor investing. We believe active, multi-factor investing can provide many of the benefits of passive options while mitigating for the risks we have described. Although factor indices have outperformed their market cap weighted counterparts, as we discussed, each factor has undergone cyclical underperformance. We believe taking an active approach to factor investing and diversifying among a number of factors can carry significant advantages in terms of reducing the volatility of a strategy s returns. Ultimately, multi-factor portfolios can address a number of variables. The expected return is only one of these, and it does not necessarily follow that investors should target higher exposure to factors that are expected to produce larger returns. We expect multi-factor strategies to outperform the market over time. As such, depending on the investor s risk appetite and liquidity requirements, we believe the volatility, drawdowns, and turnover necessary to maintain a factor exposure are equally important.
4 Conclusion In our view, there is strong evidence that investment anomalies exist, providing skilled investors a chance to outperform the market. However, we also believe that taking advantage of these anomalies is more difficult than many investors appreciate. Factor investing can be an effective way to exploit these anomalies, but single factor smart beta strategies carry many risks. Broadly, these risks include unappreciated cyclicality and poor product design. An active multi-factor approach, however, can help address the weaknesses of simple smart beta strategies through exposure to more than one systematic driver of returns. This can potentially generate balanced return streams, reduce volatility, and help mitigate drawdowns. As a result, an active multi-factor approach retains the benefits of a passive investment while opening the door to compounding above-market returns over the long term.
5 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Important Information Published on 26 February 2018. SIMULATED PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN IN THE HYPOTHETICAL DISPLAYS. IN FACT, THERE MAY BE SHARP DIFFERENCES BETWEEN SIMULATED PERFORMANCE AND ACTUAL RESULTS. SIMULATED PERFORMANCE DISPLAYS ARE PREPARED WITH THE BENEFIT OF HINDSIGHT. AS A RESULT, SIMULATED DISPLAYS THEORETICALLY MAY BE ALTERED TO OBTAIN MORE FAVORABLE PERFORMANCE RESULTS. THERE ARE OTHER FACTORS RELATING TO THE MARKETS IN GENERAL OR THE IMPLEMENTATION OF AN INVESTMENT PROCESS THAT CANNOT BE FULLY ACCOUNTED FOR IN SIMULATED RESULTS, ALL OF WHICH MAY ADVERSELY AFFECT ACTUAL INVESTMENT RESULTS. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service, or investment product. Investments in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. A quantitative investment strategy relies on quantitative models and quantitative filters, which, if incorrect, may adversely affect performance. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies securities. The securities and/or information referenced should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. The MSCI World Index is a free-float-adjusted market capitalization index that is designed to measure global developed markets equity performance. The MSCI World Index consists of 23 developed markets country indices. The MSCI World Minimum Volatility (USD) Index aims to reflect the performance characteristics of a minimum variance strategy applied to the MSCI large and mid cap equity universe across 23 developed markets countries. The index is calculated by optimizing the MSCI World Index, its parent index, for the lowest absolute risk (within a given set of constraints). Historically, the index has shown lower beta and volatility characteristics relative to the MSCI World Index. The MSCI World Momentum Index is a free-float-adjusted market capitalization index that is designed to reflect the performance of an equity momentum strategy. The MSCI World Momentum Index consists of 23 developed markets country indices. It includes those MSCI World companies exhibiting high price momentum, while maintaining reasonably high trading liquidity, investment capacity, and moderate index turnover. The MSCI World Quality Index is a free-float-adjusted market capitalization index that is designed to measure performance of the quality growth segment within the global developed equity market. The MSCI World Quality Index consists of 23 developed markets country indices. It includes those MSCI World companies exhibiting high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth, and low financial leverage. The MSCI World Value Weighted Index is based on a traditional market cap weighted parent index, the MSCI World Index, which includes large and mid cap stocks across 23 developed markets countries. The MSCI World Value Weighted Index reweights each security of the parent index to emphasize stocks with lower valuations. Index weights are determined using fundamental accounting data sales, book value, earnings, and cash earnings rather than market prices. The indices are unmanaged and have no fees. One cannot invest directly in an index. RD00199