Smart beta performance sparks investor interest
By James Williams – What was once a black and white choice for investors is now decidedly grey. Previously, the choice was either to go down the passive investment route or pay for the expertise of active managers. The emergence of – or rather growing popularity in – smart beta has changed all that. Now, investors have access to low-cost solutions that not only offer the passive feature of index products but also a range of factors or rules that are implicitly active.
Smart beta, by definition, is neither passive nor active. It straddles the middle ground combining elements of both, employing strategies that are implemented systematically.
As investor interest steadily builds in these products the USD64,000 question is: Have smart betas actually done what they say on the tin and outperform the benchmarks?
Since Man Systematic Strategies launched the Source Man GLG Europe Plus ETF on 27 January 2011 it has demonstrated solid returns. Whereas a lot of equity-based smart betas are constructed using factors to develop alternative weightings, Europe Plus is slightly unique.
Index creation is based on the best BUY recommendations provided to Man GLG by a network of 68 brokers, a third of which are global. The central premise is that by focusing on the best medium-term BUY recommendations (60 to 90 days), the index is able to deliver outperformance. What Man SS has found is that broker anomalies are fairly consistent. Between zero and 60 days the strategy is able to generate, on average, 175 basis points of excess returns. These anomalies are transient and peter out after 60 days. The system harvests the gains quickly then exits the market.
“In 2012, we outperformed the MSCI Europe Index by 534 basis points with a tracking error of just 3.3 per cent. We aim to deliver 2 to 5 per cent alpha so performance was at the top of the range. As of the end of March 2013 the strategy was pretty flat, up 2 basis points on the benchmark,” confirms Khalil Mohammed, Co-head of Equities at AHL/MSS, Man’s systematic investment specialist.
Size risk is mitigated in the portfolio by looking at the large and small cap proportions in the MSCI Europe Index and adjusting the portfolio to match those weights accordingly. “Currently, 85 per cent of the benchmark index is large cap while the rest is small cap. Ultimately, we end up with a diverse portfolio of around 200 to 250 stocks.”
Critically, the model uses a pattern-spotting algorithm. If three brokers recommend the same stock, for example, there’s more conviction and a higher weighting is applied. “If, however, there are too many recommendations in the same stock this could become a consensus risk position and we would sell,” explains Mohammed.
One trade that did particularly well in 2012 was Inditex, the Spanish stock that owns Zara, Massimo Dutti and Bershka. Throughout different times of the year, 11 different brokers recommended it as a BUY. “If one broker had put in a SELL recommendation we would have traded out of the position but in this case all the brokers were in agreement. The stock ended up outperforming the market by 60 per cent,” says Mohammed.
There were also multiple BUY recommendations for Vivendi. The first BUY recommendation occurred on 5 April and to the end of 2012, Vivendi appreciated by 42 per cent whilst the MSCI Europe Index went up by 11 per cent, confirms Mohammed.
US-based First Trust Advisors has seen investor interest grow in its range of alpha-generating AlphaDEX ETFs in recent times. Using value and growth factors to rank stocks, the products have generated good performance. Take the NYSE Arca-listed First Trust United Kingdom AlphaDEX ETF (FKU). Over the last 12 months, the Defined United Kingdom Index (which the ETF tracks) has returned 16.45 per cent whereas the benchmark MSCI United Kingdom Index has returned 9.75 per cent.
Unsurprisingly, the firm launched three AlphaDEX UCITS ETFs on the London and Irish Stock Exchanges on 11 April 2013 for European investors to access this smart beta approach. The three products focus on the UK, US and emerging market indices; the UK product tracks the FTSE 100 Index.
Market timing criticism
One criticism levelled at smart betas is that they are trying to time the markets and that investors should take heed of ‘Caveat Emptor’. This may well be true of some strategies, but not necessarily all.
London-based Global Wealth Allocation (GWA), founded by CEO David Morris in 1998, has a straightforward ethos: ‘Building Portfolios Without Prices’. With a 15-year history in running non-price weighted portfolios, it’s fair to say that smart beta is not a new concept to GWA.
“The way we operate is by following traditional economic thinking. Since we entered into a partnership with FTSE in 2005 our Japan wealth-weighted index (FTSE GWA Japan Index) has outperformed the market (i.e. the TOPIX) by approximately 900 basis points.
“We also launched the FTSE GWA Emerging Index in November 2007. This has generated 650 basis points of outperformance (relative to MSCI Emerging Markets Index),” says Morris.
Two features of GWA set it apart from its competitors. The first is this non-price weighted approach. The second is that in each of its 21 indices the portfolio of companies exactly mirrors the underlying benchmark.
At the heart of GWA’s methodology is that any index should be re-weighted using measures of a company’s wealth: namely book value, cash flow and net profit. Wealth creation, not stock market price is the strategic thinking at work here. When Morris talks about the “intrinsic worth” of the underlying productive asset he’s using a real economy concept not a stock market concept; that is, each security is a manifestation of how people divide their wealth.
“The equilibrium value or true value of a productive asset (based on its income generating power) is what we at GWA are trying to proxy,” says Morris.
“The rate of return for every company in the theoretical model is the same; competition makes it so. People find that a hard concept when you compare the rate of return on Apple to some utility company, but we assume that the system is competitive. The advantages enjoyed by Apple in the short-term will be competed away over the long-term.”
By focusing on book value each of the FTSE GWA indices is constructed based on the intrinsic worth of the underlying productive asset.
“Generally speaking, market cap-weighted indices worldwide have been flat for 13 years. But if you look at the book values of companies, they’ve tripled over that period i.e. wealth creation has tripled.
“In March 2000, the price to book ratio for Microsoft was 26. It was the biggest company in the history of the stock market at USD600billion. In March 2013, Apple became the new holder of that record: USD620billion. But its P/B ratio was just six. Apple has established its record on a huge amount of wealth creation,” says Morris.
The basic premise of the methodology is that, by focusing on the real economy, a higher weighting is assigned in the index to companies with a lower P/B ratio.
By using this non-price weighting approach, Morris unavoidably ends up with a value tilt. But Morris is quick to counter the claim that he’s a value manager:
“They [value managers] choose to invest only in value stocks that they believe provide a sufficient margin of safety and tend to only hold 100 to 150 stocks. I’m not a value manager because I don’t use this margin of safety, plus I’ve got massive diversification. Our Japan portfolio has over 400 companies in it, even though it has a value tilt. If you line up the portfolio with the intrinsic worth of the assets the market should give you a value tilt, and as I say this has proved very successful for the Japan Index.”
Mohammed responds to the market timing point by adding: “Our broker recommendations have outperformed every year since 2005, and we believe that this anomaly will continue to exist.”
Not that all investors are clambering into smart beta.
“We’ve been performing due diligence on smart beta products but as of right now we have zero capital invested. We don’t see where they can yet add value to our clients’ portfolios as they don’t necessarily help manage the issues coming from markets’ exposure; we don’t therefore envisage investing in this space, at least for the next few months,” confirms Anthony Chemla at Geneva-based B Capital Wealth Management.
The application of risk to create alternative portfolios is a strategy used by State Street Global Advisors (SSgA). Their Issuer Scored Corporate Bond Index (ISCI) strategy, which runs two indices for EUR and USD, is, says fixed income portfolio strategist Antoine Lesne, “one of the very few alternative or advanced beta products available for corporate bonds”.
Since April 2008, when the strategy launched, the Barclays US Issuer Scored Corporate Index has generated 50.72 per cent in cumulative returns compared to 46.11 per cent for the benchmark Barclays US Corporate Index. Average monthly returns (to March 2013) are 0.70 per cent compared to 0.66 per cent.
The Euro-based index has delivered 0.50 per cent compared to 0.52 per cent for the Barclays Euro Corporate Index. Volatility though is 0.41 per cent lower: 0.99 per cent compared to 1.40 per cent.
“The strategy focuses on reducing idiosyncratic risk. As such it focuses on reweighting issuers within their sectors according to how they score on two financial ratios: firstly, return on assets i.e. how well the issuer uses the money lent to generate earnings and pay bondholders back.
“Secondly, interest coverage or how easily a company can pay the interest on its debt/current ratio. The weighting of issuers is based on the evolution of these two ratios and scores are run every six months,” explains Lesne.
There is evidence that smart betas produce outperformance. But whether they can do this over the long term remains to be seen.
Richard Hannam, Head of SSgA Global Equity Beta Solutions EMEA at State Street Global Advisors (SSgA), – which offers “Advanced Beta” rules-based investment solutions – offers the following advice:
“Look through the marketing claims and be clear on the exposures the index is giving you and how this is different from cap weighted; be aware there may be significant interim volatility; be aware of active strategies being rebranded as ‘smart’ beta; and remember most of the outperformance over cap-weighted is the result of exposure to a small number of well-known factors or risk premia.”