Asset Allocator: July 2015- Eye's on Smart Beta

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: JULY 2015

 

27/07/15- Eye's on Smart Beta

 

Smart beta is sexy. I’ve personally been droning on about what I think is the next step in the evolution of ETFs for much of the last couple of years but in the last few months nearly everyone seems to have excitedly joined in – just as a I have grown a tad cynical. Barely a week goes by now without some new smart beta launch and its rapidly becoming a marketing driven crowded trade. Overall I think this innovation is to be heartily welcomed as its giving investor’s access to quantitative ideas that have been used by massive investment institutions for generations. In simple terms its democratising sensible investment strategies in a low cost fund wrapper! At the core of this revolution is the acknowledgement that not all shares are created equally. Different shares are impacted by different factors, nearly all based around some measure of risk. Small cap shares for instance outperform over the long term, largely because they are riskier. By contrast some more defensive orientated stocks tend to outperform for prolonged periods of time by exhibiting less volatility and more quality earnings. So far so good. But simply acknowledging the existence of these ‘factors’ isn’t the same as building a successful investment strategy. The devil is very much in the detail. How does the index work? What are the rules behind the index and how are different stages of the investment cycle likely to impact different factors? More to the point, is the factor just a statistical artifact or a robust, permanent phenomena i.e has the index developer simply used data mining to find a trend that has now vanished or is the factor actually robust over many decades?

My own growing sense of cynicism is that all manner of smart, intelligent indices are being created, some of which will be of enormous value, others less so i.e rather like active fund managers, where some are brilliant, others very much the opposite. As I keep repeating, the devil really is in the detail and investors need to properly understand what’s inside their index.

So it’s against this back drop that I’ve been reading two recent papers on indices and investing – one by a bunch of academics, the other by the internal index team at Societe Generale. Both have important and profound implications for any investor – professional or private – looking to invest in smart beta funds.

The first paper is called “Factor-Based v. Industry-Based Asset Allocation: The Contest” and is by academic researchers Marie Brière of Paris Dauphine University, and Université Libre de Bruxelles (ULB), and Ariane Szafarz Université Libre de Bruxelles (ULB),  and was published in July of this year.  

Marie and Ariane have done investors the valuable service of comparing different smart beta strategies – factor based indices – with more traditional sector based indices within the equity universe. Crucially though they’ve concentrated on two fairly under researched themes namely what effects varying economic/market conditions have on returns as well as the impact of short-selling.  In terms of the factor indices used in the study Briere and Szafarz have focused on the main factors identified by US economists Fama and French although the authors concede that there’s a much wider range of factors available. In fact the research literature “proposes over 300 such factors, which are supposed to deliver excess returns: a key question is whether they represent a sustainable risk or rather temporary market anomalies that will disappear when discovered?”. Quite!

But the most important twist in this study is that juxtapositioning of these newer smart beta factor indices against more traditional sector indices. How do these rival indices stack up? The academics conclude by saying that “we find that factor investing dominates sector investing in every aspect when short sales are unrestricted. To a lesser extent, our results suggest that factor investing is also more profitable during expansion times and bull periods, even if short selling is forbidden. However, sector investing delivers better—or less bad—performances for long-only portfolios during recessions and bear periods. [my emphasis added]“

“Overall, we show that factor investing is worth attracting the attention of investors with low to moderate risk aversion. At the same time, it stresses that factor investing performs best when it takes full advantage of short sales, which can be tedious, if not impossible, for individual investors to implement. Nowadays, the emergence of dedicated indices and funds has made factor investing more accessible to those investors. However, not all identified factors are investable in this way…Therefore, a major challenge for the advocates of factor investing is the practical implementation of the investment rules they recommend.”

This for me nails an absolutely crucial point – construction of the indices and their investability is massively important. This line of enquiry shines a spotlight on the issue of trading. The authors observe that “Factor investing is not only a transaction-intensive style, it also a good performer when short selling is permitted. But short sales imply additional expenses, such as borrowing costs. Accounting for all the costs could actually make passive strategies more competitive”.

At this point it’s worth switching focus by examining the equally cogent criticisms contained within another July research paper, this time by a Societe Generale research team headed by Andrew Lapthorne working alongside index specialist John Carson. In their most recent Global Style Counselling report, the SG researchers challenge the conventional idea that passive indices are…well…passive i.e they don’t trade very much. If as is increasingly obvious these indices are actually fairly active, then surely smart beta indices will be even more active? This might in turn open up investors in these tracking funds to extra trading costs and the risks of front running by experienced institutional investors.

Let’s start with that point about mainstream passive indices being more active than we first thought. The reports analysts observe that the “MSCI World, an index of around 1,600 stocks, saw over 4,000 weighting changes last year. Yes, you did read that correctly, 4,000 weighting changes! Little wonder the Index Watch team is busy. Of course, many of the changes are so minor that they require little if anything in the way of trading, but the Index Watch database records around 1,100 weighting changes in 2014 that they do consider to be significant. Once added up, all these changes can amount to significant two-way turnover.” The table below shows the turnover of a wider series of mainstream benchmark indices.

 

All of these transactions might well have an impact on trading costs – and thus returns. The SG report notes that “since 2003, the performance spread between MSCI World index review additions and deletions has averaged around 10% from the period 20 days prior to the announcement date to 20 days post the announcement date. And even as recently as two years ago, these returns were much higher. So for the passive fund rebalancing on the effective date, new entrants will cost more and the deletes will be sold at a discount to where they stood. Sadly for the passive fund, that does not seek to mitigate these rebalancing issues, the “delete” losses occur in the index, while the “add” gains happen outside the index.”

The study argues that investors can already witness the impact of this trading in real world markets. Observing that when Wisdomtree recently announced the latest adds/deletes to its increasingly popular currency-hedged European index, there were notable share price movements in those companies affected. “Yet the ETF tracking this index is just $20bn in size”.

The authors then train their analysis on smart beta indices built around four main groups of risk factors:

1) Value: Composite score based on five sector relative value factors (trailing PE, FY1 PE forecast, last reported price-to-book ratio, trailing free cash flow yield and trailing EV/EBITDA ratio).

2) Momentum: 12-month residual momentum lagged by one month.

3) Quality: Composite score based on six-month volatility, five-year monthly beta, the Merton model and the Piotroski model.

4) Profitability: Composite score based on trailing return on assets, return on equity, return on invested capital and gross profitability.

The next three tables contain the incendiary results: that turnover is massively increased in smart beta funds, with trading costs also rising substantially, producing an inevitable hit on total returns. In each table authors compare a traditional market cap based index (MCAP weight) with four factor versions and an equal weight index over the period 1995 through to 2015. 

 

 

 

What’s immediately obvious is that although smart beta indices may produce out performance in the long run – and in some cases dampen down volatility – it’s not a risk free trade. Transactions increase substantially, as do costs and investors might find returns lagging behind as a result over long periods of time.

The SG analysts conclude their exhaustive analysis with some advice for investors:  

“1. Be careful when using an index as the basis for your smart beta exposure. Use the concepts, factors and constructs, yes, but deploy them in a bespoke way.

2. Rebalancing on one day along with everyone else, especially when the market knows what you need to trade, is madness. Trade away from the crowd and over multiple days if possible.

3. Multi-factor approaches at the stock rather than index level work best. The opportunity to net off trades, minimise volumes and market impact should reap benefits in the long term.”

 My bottom line?

I’ve become increasingly concerned that much of the excited talk about smart beta which seems to suppose an almost risk free trade. It’s almost as if index specialists assume one can Identify a robust factor that rewards you for taking extra risk, sit back and then enjoy the out performance through the cycle. Unfortunately it’s not quite that simple. Our first academic study observes that different factors out perform during different markets i.e small cap based factor indices might work some of the time during bullish markets, but not all the time. Smart beta indices based on risk factors might also increase costs, and diminish returns over time as all those transactions start to build up. My own sense is that unless you are a very active investor willing to mix and match different strategies in different market conditions, a multi-strategy approach might work best i.e combine different factors in one diversified portfolio. But this multi-factor diversification might end up self-defeating – your portfolio might not look that different from a traditional passive index! 

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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