Multi-factor products begin to offer absolute-return potential
There was a clear example this April of just how far smart beta investing has come. Goldman Sachs Asset Management (GSAM) announced that it had agreed to acquire Westpeak Global Advisors, a firm that offers full-customisable solutions for smart beta investing; a clear sign of endorsement by GSAM that this area of equity investing has value.
At the same time, GSAM announced the launch of an Advanced Beta Strategies platform. The platform combines Westpeak’s smart beta business with GSAM’s S&P Global Intrinsic Value Index (GIVI®) strategies, a set of tax-sensitive equity strategies, and a range of liquid alternative beta strategies. The new platform will be overseen by Armen Avanessians (pictured), head of GSAM’s quantitative business.
“This acquisition reinforces GSAM’s focus on investment innovations across global equity markets,” says Avanessians. “Westpeak’s proprietary ActiveBeta® Strategies complement well GSAM’s existing capabilities in the beta space, which includes liquid alternatives, rules-based, and tax-efficient strategies. The combination of these capabilities, inclusive of Westpeak’s proprietary factor-based equity solutions, form our new Advanced Beta Strategies platform, which we believe is critical to our engagement with our clients.
“We believe that Advanced Beta will be among the most prominent trends to emerge in the asset management industry over the next decade.”
Through the identification and implementation of investment factors (e.g., value, momentum), investors have the opportunity to achieve a more efficient capture of the broad market, says Avanessians, adding: “ActiveBeta® Strategies is a fully customisable smart beta solution. For example, investors can:
- Customise the capture of individual and diversified factor returns at desired levels of target tracking error (i.e. customise risk tolerance);
- Create customised factor diversification strategies to reflect their philosophical biases (i.e. customise beliefs);
- Develop customised solutions to help them better manage portfolio exposures and design completion strategies (i.e. customise exposure risk).”
One area within smart beta that asset managers are increasingly focusing on is the development of multi-factor products. This is, in large part, being pushed by institutional investors who, over recent years, have grown increasingly comfortable with single factor investing but who are now looking for more effective implementation using a multi-factor methodology.
This year, State Street Global Advisors (SSgA) announced the launch of a multi-factor solution to allow investors to combine more than one risk premium in a single portfolio.
“Say an investor likes value and quality factors and they have two separate portfolios – high quality stocks may mean higher valuations so the investor might be buying a given stock in one portfolio and selling it in the other. If they had a combined portfolio they could hold those stocks for a bit longer – but maybe at a lower weighting. Multi-factor investing can make the implementation process more efficient if the investor believes in more than one factor,” comments Ana Harris, portfolio strategist at SSgA.
Running a multi-factor portfolio rather than numerous separate portfolios also helps to reduce trading costs.
Harris confirms that SSgA has two multi-factor index products in the pipeline – “one for two factors, one for three factors”, she says. These indexing products are geared more towards sophisticated institutional investors who prefer to have segregated mandates. Having said that, SSgA has also filed for approval to launch a multi-factor ETF in the US.
“The ETF would track MSCI Quality Mix Indexes, a multi-factor index launched by MSCI at the end of last year,” says Harris.
The three factor indexes that make up the composite index are: MSCI Value Weighted, MSCI Minimum Volatility and MSCI Quality.
Herve Foucault is Head of Business and Product Development at Risk Based Investment Solutions (RBIS), a subsidiary of the Rothschild Group. Its approach to product evolution within smart beta has been to develop a matrix that seeks to measure stock volatility and correlation and create Equally-Weighted Risk Contribution (ERC) index portfolios for its clients. It is a ‘risk to weight’ methodology rather than ‘weight to risk’ methodology long used by market cap-weighted indexes.
“As soon as you introduce more than one component into the portfolio you have what we call ‘hidden assets’; these are the correlation between each stock and their individual volatility. If you focus on the hidden assets in the portfolio construction process this is the most efficient way to extract value from them.
“At Rothschild, we believe that combining volatility and correlation to create an Equally-weighted Risk Contribution portfolio is the next stage of the smart beta evolution,” comments Foucault.
This is not to suggest that single factor investing is about to become redundant. Indeed, SSgA’s Harris says that there are still plenty of its large clients still using single factor in separate portfolios.
Popular indexes like the Nikkei225 are tentatively entering the smart beta arena to deliver something new for investors. On 6 January 2014, Japan Exchange Group Inc, Tokyo Stock Exchange Inc and Nikkei Inc began calculating a new index: the JPX-Nikkei Index 400.
“The index employs an element of smart beta filtering with cap-weighting,” says Ari Rajendra, Synthetic Equity and Index Strategist at Deutsche Bank. “More of the established index providers like MSCI, FTSE and STOXX have started to construct new smart beta indices, which appeal to a broader investor base. As a result, we could see ETF assets tracking these indices to grow significantly in the future.”
Nikko Asset Management, one of Japan’s largest ETF providers, launched the JPX-Nikkei Index 400 ETF. Crudely speaking, the difference between the new index and the TOPIX is that the TOPIX is market cap-weighted on 1,700 stocks. The JPX-Nikkei Index 400 uses qualitative and quantitative criteria including return on equity (ROE) and the degree of governance within individual companies to select high quality companies.
“In Japan what you’re beginning to see is the early evolution of products from cap-weighted towards a smarter outcome. This is certainly more sophisticated than products that have launched previously in Japan. The JPX-Nikkei Index 400 uses a combination of quantitative and qualitative inputs, including measures of governance and investor reporting, to focus on better managed companies,” comments Geoffrey Post, Head of International Product Development at Nikko Asset Management.
One firm that has been particularly successful in developing a scalable smart beta strategy is Man GLG. Since 2005, GLG partners has been collecting the best BUY recommendations from a network of 65 European brokers to run its Europe Plus strategy of between 200 to 250 stock positions. In 2011, ETF provider Source teamed up with Man GLG to launch the Source Man GLG Europe Plus ETF, which has grown to approximately USD800bn in AuM.
After deciding to extend the strategy to Asia Pacific in 2010, Man GLG launched two new ETFs last September: Source Man GLG Continental Europe Plus (which excludes UK equities) and Source Man GLG Asia Plus (which excludes Japan). Both have grown to around USD130mn and there are now plans afoot to widen the strategy even further to incorporate broker ideas from Japan and North America.
“At the start of 2014 we began talking to Japanese and North American brokers. We now have 27 brokers in Japan giving us their best recommendations whilst in the US we will have around 40 brokers contributing ideas. We haven’t given any firm dates to clients on when we might launch the Japan and North American strategies as it is dependent on the idea pool and the strength of the alpha.
“We know there is around 100 basis points of alpha (over 30 to 60 days) to be extracted in North America but we want to be sure that there’s enough alpha to allow us to run a well diversified strategy,” explains Khalil Mohammed, portfolio manager at Man Group.
These are all interesting developments but one firm that is keen to add academic ballast to the multi-factor approach to smart beta investing is EDHEC-Risk Institute, whose indexing arm ERI Scientific Beta has recently been promoting the virtues of what it calls ‘smart factor’ investing.
The ‘smart’ part is the weighting scheme. One of the problems when moving away from the market cap-weighted model to alternative weighting models is that if you don’t have sufficient diversification of the factor you might end up being highly concentrated in a number of stocks; e.g. a low volatility factor tilt might produce a concentration of utility stocks in the portfolio, thus creating sector bias.
“So the ‘smart’ element for us is the diversification element. We have various diversification schemes all of which we think have merits. These include: Maximum Deconcentration, Maximum Decorrelation, Diversified Risk Weighted, Efficient Minimum Volatility and Efficient Maximum Sharpe Ratio,” explains Peter O’Kelly, EDHEC-Risk Institute’s Director of Marketing.
The ‘factor’ part includes four specific risk factors, which academic research has shown deliver reward to investors over the long term. These include: high momentum, small size, low volatility and value.
What the ERI Scientific Beta team then does is combine the four risk factors with the five different weighting schemes to diversify away all the unrewarded risk.
“The ‘smart’ part is diversifying away unrewarded risk and the ‘factor’ part is the quality of the risk factors being used,” adds O’Kelly.
Felix Goltz, Head of Applied Research at EDHEC-Risk Institute said that such an approach allows investors to manage systemic risks through explicit stock selection, and also to diversify strategy-specific risk by combining different strategies.
“ERI Scientific Beta allows investors to benefit from additional factors with reduced specific risks, which simple cap-weighting does not allow,” Goltz was quoted as saying.
One of the problems with single factors is that whilst they have been proven (academically) to reward investors over the long term, that’s not necessarily the case over the short term.
“Low volatility might do well in a bear market but less well in a bull market but if you diversify your factors you might be rewarded for momentum, for example, at a time when volatility is still low. The aim is to diversify your factors to do well in all market conditions and diversify your weighting schemes to reduce any unrewarded risk,” adds O’Kelly.
Amundi has partnered with ERI Scientific Beta to develop a global index base on this smart factor methodology.
“We do an equal risk-weighting contribution for each of the four risk factors and in the end this gives us a smart combination of factor selection and weighting schemes used in the index construction,” explains Mathieu Guignard, Director of product development, ETF & Indexing at Amundi.
By combining all four factors to construct the index, the objective is to deliver better performance in all market conditions. What this shows is that smart beta investing, by adopting a multi-factor approach, is beginning to offer investors more of an absolute return solution.
“We have worked together with ERI to create a global index – the ‘Scientific Beta Developed Multi-Beta Multi-Strategy ERC’ index – and plan to launch an ETF this June. Partnering with ERI offers us many ways to customise indexes for clients. We can technically do it for any geography and customise the approach itself for client mandates. If a client isn’t convinced by the momentum approach we could remove it from the stock selection process in the index creation and just use the other three factors,” says Guignard.
Looking ahead, SSgA’s Harris says that the next step in factor investing will be how to apply it beyond equities. The reason why smart beta lends itself so readily to equities is because the data to build passive strategies is readily available. Moreover, the variety of parameters used for measuring equities is way beyond other asset classes like fixed income.
“In fixed income, because there’s less data available there’s been less growth in passive strategies. However, what could boost the growth of fixed income passive strategies is applying this concept of smart beta. Thinking about other ways to construct indexes beyond the historic debt-weighted approach; are there any quality thresholds that could be used to better construct fixed income indexes?” opines Harris.
Foucault confirms that RBIS is applying the same ERC philosophy to fixed income and commodity futures. Wth respect to fixed income indices, he comments:
“As we can maximise the risk budget using the ERC approach, we believe there is more value using this hidden asset approach to budget the risk country by country with regards to their respective GDP. If a country has twice the GDP of another we’ll allocate twice as much risk exposure.”
This is the opposite approach to debt-weighted fixed income indices where countries with the highest levels of indebtedness have the highest weightings.
“Because we have the same rationale to weight each portfolio based on the risk budget associated line by line it makes it easy to combine asset classes. We will be able to combine equities and bonds in one portfolio to achieve the same objective but in a multi-asset profile that we can compare to other traditional multi-asset class portfolios,” concludes Foucault.