Asset Allocator: July 2015- Discovering Smart Beta

In this week Asset’s Allocator, David Stevenson introduces investors to the evolving industry of Smart Beta by reporting the results of two recently conducted surveys. David rounds up the four basic points to take into account if when examining 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.

 This article has been published for marketing purposes and has not been prepared in accordance with those legal and regulatory requirements which are designed to promote the independence of investment research. There has been no prohibition on dealing ahead.  It was not subject to any prohibition on dealing ahead  prior to its publication on this website.

 


ASSET ALLOCATOR: JULY 2015

 

02/07/15- Discovering Smart Beta 

 

Smart beta is a relatively new investment term but over the last few years we’ve seen a veritable explosion in the number of products built around the theme of more “intelligent”, alternative indices.  Barely a week goes by without some new ‘smarter index/ETF’s being launched although, whether this new form of index tracking is quite as mainstream as some maintain is (in my humble opinion) rather up for debate – my column next week in industry newspaper Investment Week questions whether smart beta is perhaps a little too intelligent for many professional investors!

But there’s no doubting that amongst professional investors, especially at the larger institutional level within asset management, smart beta funds and trackers are becoming a crucial part of the portfolio construction process.

Two recent surveys on smart beta were conducted by the French business school EDHEC - sponsored by Societe Generale and detailed in the box below - throw valuable light on the use of smart beta products. Crucially, they offer all investors (institutional and otherwise) valuable lessons about what to watch out for when using smart beta funds.  

But before we use explore these themes, let’s first nail down exactly what it is we are talking about when we discuss smart beta. Perhaps the clearest definition for me comes from the US based Research Affiliates, pioneers of the fundamental RAFI indices. They argue that smart beta funds split into two main camps – popular heuristic-based weighting policies which “include equal weighting, fundamentals weighting, risk-cluster equal weighting (where risk clusters, instead of individual stocks, are equal-weighted), and diversity weighting (which combines equal weighting and cap weighting)” as well “optimized strategies including minimum variance, maximum diversification, and risk efficient indices.”

I think it’s also useful to accept that smart beta indices have gone through numerous iterations in recent years. The very first wave of smart beta indices, focused on a small number of simple ‘risk factors’ or risk premia’, i.e fundamental indices that used value based ideas centered on the balance sheet or dividend payouts as a key measure.

Optimised strategies such as low or minimum variance represented the next generation of indices, but even these relatively innovative products are now being over taken by multi factor models – where momentum and say low volatility measures are used to construct an index.

EDHEC research reports

 

Alternative Equity Beta
Investing: A Survey
March 2015

Noël Amenc and Saad Badaoui as well as Felix Goltz and Véronique Le Sourd

 

EDHEC-Risk Institute Publication

Investor Interest
in and Requirements
for Smart Beta ETFs
April 2015

Felix Goltz and Véronique Le Sourd

 

 

What’s clear is that whatever smart beta generation, a growing number of institutional investors are indeed using these ‘intelligent’ products. The chart below shows that 25% of the managers surveyed already use products tracking smart beta indices, while another 40%  are considering investing in them in the near future.

But, what is also clear from the EDHEC survey is that amongst active users of smart beta products, most are still sticking with first and generation products – with low volatility and fundamentally weighted indices- by far the most popular as seen in the next chart below. 

 

Yet as we dig deeper into the EDHEC Research I would argue that four very valuable learning points start to emerge.

1. Smart beta products are overwhelmingly used for risk mitigation, within the equities space and on a long only basis.

The EDHEC analysts reveal that “Among long-only strategies, Low Volatility, Equal-Weighted and Value Strategies have the highest….Decorrelation/diversification strategies have the lowest familiarity, among long-only strategies, even lower than some long/short strategies.” For me the relatively low usage of momentum based tracker is hugely important. These surveys suggests that investors are looking to manage their downside risk by investing in low vol stocks or shares where there is some margin of safety based on the balance sheet of the individual businesses. Investors are NOT using these products to gear up positive returns or make money by going short. Crucially they aren’t looking to capture upside momentum. The EDHEC researchers also reveal that although many of the respondents understood the concept of equal weighting as an index construction methodology, most tended to avoid using these indices. My own sense is that if investors were using smart beta to boost any upside potential, they’d be making extensive use of equal weighted indices, momentum trackers and products that make money from shorting markets. One last observation – as the next box below indicates, most of those surveyed in the reports think that value based indices will continue to provide the best returns moving forward.

2. Smart beta is no replacement for Active managers.

Much of the excited talk about smart beta has been predicated on the idea that these intelligent trackers represent a mid-way house between active fund management and passive beta, which rather implies that many investors might be tempted to switch out of more expensive active funds for smarter beta products in the future. But when the EDHEC researchers actually asked users why they adopted smart beta ETFs the largest number – 35% - said “they would like to increase use of ETFs for optimal portfolio construction, an increase of 2% from last year (as well as from the year before). An implication of this planned increase in using ETFs in optimal portfolio construction is that respondents see ETFs not only as purely passive tools to cover broad market segments, but they also want to exploit diversification benefits from optimally-constructed portfolios that combine various ETFs”.

The table below reinforces this response and suggests that investors make use of smart beta trackers as a way of diversifying portfolios and NOT as a replacement for hedge fund managers or active mutual fund managers. 

3. There’s still plenty of opportunity for new products.

Even though we’ve seen a massive increase (from an admittedly low base) in the availability of smart beta products, we shouldn’t expect the pace of innovation to slow down any time soon. My own sense is that there’s still a huge new range of products out there that could come out in the next few years – the chart below shows what kind of products the EDHEC respondents would like to see developed. Given that most ETF issuers spend a huge amount of time canvassing their institutional clients as a source of product innovation, I’d suggest we’ll soon see a wave of smarter emerging market indices, multi-factor diversified smart beta ETFs, and bond/fixed income ETFs.

4. A research based due diligence check list.

Perhaps the most useful insight from the reports centres on what investors in smart beta products think you should look out for i.e the snags and challenges with using these new ETFs.

For me the most revealing insight is the EDHEC conclusion that “respondents allocate relatively few resources to evaluation of alternative beta. The average respondent uses fewer than two full-time staff to evaluate alternative beta offerings, a much lower number than used to evaluate active managers.”

I find this a real revelation – if we are to believe these findings, most institutions haven’t really developed a deep, in house research expertise when it comes to smart beta. That rather implies that all those financial seers predicting that active management is dead have completely missed the point. Smart beta is under-researched, under used and misunderstood and active fund management is very much alive and kicking. That in turn rather implies that there’s still huge room for growth, and opportunity within the smart beta space. 

But first investors need to be much more intelligent about how they use these products. Again the EDHEC report – as demonstrated in the last table below – is incredibly useful in itemising the investor’s ‘concerns’ about smart beta. 

These responses allow us to compile what I think is an essential checklist for smart beta investors, i.e a due diligence list of concerns about investing money.

- Find out more about the index and how it has performed in various markets in the past. Crucially investors need live and after cost daily performance numbers for any smart beta index. If the index provider does give this information, avoid it!

-Consider also, using this performance data to look at how much the index changes in composition terms every month or quarter, i.e examine how the index ‘turns-over’ on a regular basis.

-Ask if there is any independent research available on the ideas behind the smart beta index, i.e white papers and research notes.

-How much extra in terms of fees – in basis points – are you paying for the index construction? In my opinion, a range of between a few basis points and 0.20% seems reasonable, but anything much above 0.40% needs some explaining.

-Understand the index rules and explore any white papers that give a deeper, research based understanding. 

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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.

INDEX DISCLAIMER

The indices referred to herein (the “Indices”) are not sponsored, approved or sold by Societe Generale. Societe Generale shall not assume any responsibility in this respect.


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