Institutional interest in smart beta continues to grow
A recent survey of 300 institutional investors in the US and Europe by State Street Global Advisors (SSgA) – “Beyond Active and Passive, Advanced Beta Comes of Age” – found that 42 per cent of investors currently use advanced beta (or smart beta depending on your semantic tastes) and a further 24 per cent plan to do so over the next three years.
In addition, research conducted by Amundi in partnership with EDHEC-Risk Institute to measure investor interest in smart beta yielded similarly positive results among a poll of 200 European institutional investors. What it found was that the market was split into thirds: one third are currently investing in smart beta products, one third are considering it and one third are not.
“The trend in Europe is clearly growing. Index providers and asset managers have done a lot of work educating investors on smart beta. The space itself has also evolved from fairly basic single factor strategies (e.g. value, momentum) to more sophisticated multi-factor strategies. People realise that investing in one risk factor could be more efficient in certain market conditions but less efficient in other market conditions,” comments Mathieu Guignard, Director of product development, ETF & Indexing at Amundi.
Smart beta uses a rules-based approach in an attempt to harvest both alpha and beta by constructing alternatively weighted indexes to that of the traditional market cap-weighted model; which still dominates portfolio construction but which fails to adequately reward investors with respect to various risk factors. In particular these include size, value, momentum and minimum volatility, which have delivered long term risk reward according to academic literature.
“I’m part of the passive equities team and most of the discussions we are having now with clients revolve around ‘advanced beta’. Five years ago, those discussions would probably have centred more on cap-weighted indices,” says Ana Harris, portfolio strategist at SSgA.
If, as the above studies show, more than half of institutional investors will be using smart beta strategies in the near future, it would signal a real coming of age for this asset class and clear evidence that investors are looking for ways to diversify across both their passive and actively-managed portfolio allocations.
“Advanced beta strategies play an important role in helping investors to construct holistic investment strategies while keeping risk and costs in check,” said Lynn Blake, CIO, global equity beta solutions at SSgA when its report came out. “The recent spike in equity market volatility, and a reduced appetite for active strategies, may encourage further adoption of advanced beta based on its track record of improving risk adjusted returns.”
Indeed, in its DB SYNDEX Outlook Report 2014, Deutsche Bank found that the attraction of getting higher risk-adjusted returns through lower-cost index products led to around 25 per cent of ETF inflows going into alternative beta strategies – this is a theme that Deutsche Bank expects to continue in 2014.
The most popular smart beta ETF in 2013, in terms of inflows, was the MSCI Emerging Markets Minimum Volatility product issued by BlackRock. It attracted USD1.76bn of net inflows.
Figures released by Russell Indexes on 16 April 2014 show that its fundamentally weighted index series – where stocks are ranked based on economic factors rather than stock price – outperformed normal cap-weighted indexes in 2013. The Russell Developed Europe Index returned 22.3 per cent in 2013 whereas the Russell Fundamental Developed Europe Index returned 24.6 per cent.
“What smart beta represents is actually very powerful. It’s a form of performance attribution. In the past institutions bought funds that gave them exposure to US mid cap or large-cap stocks only. They didn’t provide a level of granularity on specific risk factors whereas now the growing range of smart beta ETFs is allowing investors to be much more specific on risk factors,” comments Dan Draper, Managing Director of Global ETFs at Invesco PowerShares.
PowerShares has arguably the longest history in sponsoring smart beta ETFs, with Draper adding: “We have the broadest range of smart beta ETFs, as well as the greatest number, with historical track records of greater than five years than anyone else in the ETF industry. PowerShares offers both single and multi-factor products; for example, our FTSE RAFI range, where we bring together a combination of single factors in a way that can add value to investors’ portfolios.”
In order to meet the growing demand from institutional investors, asset managers and index providers are pushing smart beta into a new realm.
As mentioned, the single factor approach is now tried and tested. Apply a factor tilt such as small size to filter stocks with the highest value to reconstruct an index and away you go. The investor gets exposure to a value-based index using a variety of potential different weighting schemes – let’s say fundamentally-weighted to keep it simple.
This highly popular index creation approach can best be thought of as ‘smart beta 1.0’.
Now, the shift is towards creating indexes that use a multi-factor approach: ‘smart beta 2.0’.
This is something that Risk Based Investment Solutions (RBIS), a subsidiary of Rothschild Group, has been focusing on and which has led them to create the Equally-weighted Risk Contribution (ERC) model to portfolio construction; something that Herve Foucault, Head of Business and Product Development, refers to as “the next stage of the smart beta evolution”.
Later in this report more detail is given on the evolution of the smart beta product space, but in brief what Rothschild has done with its ERC model is minimise unwanted risk by creating a matrix combining two risk factors – volatility and correlation – to produce a portfolio where each position contributes the same level of risk.
The methodology is completely transparent and one where RBIS encourages its clients to perform the weighting calculation themselves to prove that it is indeed doing what it says on the tin.
“They can ask us questions to determine whether what we are doing is just marketing (playing on the ‘smart beta’ theme) or if there is really something behind our approach. Can they effectively monitor the risks we are talking about? In the early days of smart beta you weren’t investing in a methodology but the constraints applied to that methodology.
“This is something that investors want to clarify with smart beta providers – are we actually delivering the product or are we delivering something that looks like it?”
By providing the weightings on a given index to the investor they simply need to multiply them by the volatility and correlation in the matrix and what they should end up with is an equal risk weighting for each position in the index.
With market cap-weighted, the weights of each stock are known from the start. The observable output is the correlation and volatility (risk factors) of the portfolio. What RBIS is doing with its ERC approach is to flip that completely on its head.
“At RBIS, we begin with the risk factors and make weighting the output. We have moved from a ‘weight-to-risk’ process for portfolio construction to a ‘risk-to-weight’ process. This is the paradigm shift,” notes Foucault.
Evidence of this new era for smart beta can be seen by the recent announcement that both Amundi and Morgan Stanley have signed partnership agreements with ERI Scientific Beta (the indexing arm of EDHEC-Risk Institute). Their platform is designed to empower investors by leveraging academic research to provide better transparency and risk controls.
“We believe that investors should be able to decide what to do based on their investment beliefs. Our platform is giving institutions the opportunity to decide what they want to achieve with a particular index; all we are doing is providing the tools,” says Peter O’Kelly, EDHEC-Risk Institute’s Director of Marketing.
What the Scientific Beta team has done is create a ‘smart factor’ methodology for what it calls a Multi-Beta Diversified Multi-Strategy Equal-Weight Index; quite a mouthful but what it essentially means is that investors can get exposure to global equities using four factors – small size, high momentum, value and low volatility. Five different weighting strategies are then applied to each risk factor to build the index.
Amundi has created its own global index using this approach with ERI Scientific Beta, which is now available to institutions.
“It’s a new way to offer our index capacities to clients,” says Guignard. “Talking about this new era of smart factor investing (smart beta 2.0) has clearly generated some interest from clients.
“The flows we’re seeing into smart beta at the moment are more in dedicated mandates than ETFs. Large institutions usually prefer tailored solutions rather than open-ended products.”
Using an open architecture is sating investor appetite for greater transparency in the smart beta space and perhaps explains why investor demand for these alternative indexing options is on the rise. “Investors can see inside the index. The ERI Scientific platform gives investors access to performance and risk analytics on all the indices at any time, so there are clear transparency and risk control benefits to clients,” adds Guignard.
But not all investors are pursuing this multi-factor approach to indexing. SSgA’s Harris says that for most clients smart beta is a journey, with different clients at different stages of that journey. Most are still in the early stages of embarkation and therefore favour the single factor approach.
“The larger institutions that have more internal resources or have a mandate to broaden their allocations are at the forefront of this trend. It also seems to be more popular within Europe than the US and in particular, countries like the Nordics,” says Harris.
“The majority of clients are still just looking at single factors. Investing in factors is a significant departure from thinking about stocks and investors need to build their level of comfort with this approach. Most are at the stage of implementing a single factor methodology either to diversify their passive allocation (cap-weighted) or reduce some of their active manager allocation,” he adds.
What EDHEC is doing is refining a lot of the portfolio construction “but it may be hard to explain where performance is coming from when you introduce added complexity”, suggests Harris.
When assessing what makes a good smart beta product, Draper says that transparency and understanding the methodology are crucial for institutions because of the fiduciary responsibility they have to their end-investors.
“They need to be able to explain why they are buying a particular ETF to fit a particular purpose in the portfolio. So having an index methodology that is well tested, effective and can be clearly communicated is key. But also, because of the large investment positions that institutions put on, trading liquidity of an ETF is a key consideration.
“For institutional investors, fund size and liquidity are important differentiating factors for smart beta ETFs. You can have the greatest methodology but if it’s only got USD20mn in AuM institutions are not going to be interested,” says Draper.
Indeed, the Invesco PowerShares RAFI range is over USD6bn.
“A good example is our PowerShares Senior Loan Portfolio, which is now heavily used by institutional investors. Senior bank loans are OTC products but the fact that we put this product on the stock exchange means investors can now buy a million shares of that ETF at a four basis point spread. That is much tighter than going out and buying individual senior bank loans in the OTC market. The ETF wrapper has enabled us to really bring liquidity to that underlying asset class,” says Draper
He adds: “Before we bring anything to market we’ve already had a lot of dialogue across the entire value chain, starting with our clients. It may be a great idea but how practical is it? Will it work in the marketplace? Will it attract liquidity? That’s where having a strong track record of bringing smart beta ETFs, like ours, makes a difference.”