Factoring in a smart approach

26-Dec-2016

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Smart beta indexes and the ETFs based upon them have seen huge growth over recent years. Their ability to sit midway between active and passive investment management has endeared them to an audience of investors who have been floundering in a low interest rate and expensive equity environment.

According to data from Morningstar, global assets under management in smart beta indexes in 2015 had risen to USD616 billion, from USD103 billion in 2008. It is now estimated that as much as 20 per cent of the USD3.2 trillion ETF industry’s assets are linked to smart beta products.

Smart beta or factor investment is based on rules-based systematic weightings to create indexes that allow exposure to factors such as volatility or momentum. They offer investors access to simple, cost-effective diversification in their portfolio.

Smart beta ETF demand has increased on the back of worldwide regulatory changes that have put advisers into a fiduciary role for their clients, working on a fee-based basis which levels the playing field between financial products. Low cost, nimble and transparent ETFs are having their day in the sun, and the smart beta variety is proving particularly popular.

Other drivers have been the low interest rate environment and perennial search for income, and jittery markets, set off by macro events such as political change and unrest, pushing investors to seek diversification as a risk control measure.

The roots of smart beta lie in the application of economic theories to investment models that started in the 1930s with David Dodd and Benjamin Graham and advanced through to the 1950s with Harry Markowitz and modern portfolio theory, to today where diversification in a portfolio is still highly prized and now achievable in a low cost, transparent and efficient way through ETFs.

And the rise of smart beta is gaining traction in Europe as well. A recent study from Invesco PowerShares, conducted by CoreData, found that a wider understanding of smart beta products and how they can be integrated into a portfolio is increasing the belief that these strategies will become more popular in Europe over the next three years.

This research was conducted among current users and non-users of smart beta in the UK, France, Switzerland, Italy, and Germany. Of the users surveyed, 71 per cent agreed that smart beta will become a widely accepted investment over the next few years, compared to 60 per cent in 2015. From a country perspective, confidence in smart beta becoming more widely accepted was strongest in France (79 per cent) and the UK (78 per cent). Building upon this, 73 per cent of smart beta users now recommend smart beta to colleagues and investment professionals.

Diversification won out among the objectives listed in using smart beta strategies but the need for control is another major theme spurring investment in smart beta. Smart beta users in France responded that the desire to control risk factors was the most important reason for investing.

Control was huge, first through transparency and then through the systematic rules-based nature of these strategies. When asked directly, 63 per cent of users agreed smart beta offers greater control than any other investments.

Finally, another winning point for smart beta ETFs is that they can easily be employed in existing portfolios. If you can buy an equity, you can buy an ETF so no portfolio overhaul is needed to incorporate them.

In terms of performance, ETF data providers ETFGI report that for the year to June 30, 2016, ETFGI’s most recent data show that assets in smart beta funds have a five-year annual compound growth rate of 31.3 per cent.

Market analysts MPI wrote in their October white paper entitled Lower Volatility Smart Beta Funds – A Safe Haven in Turbulent Times? [www.etfexpress.com/2016/10/06/244489/mpi-details-how-hot-smart-beta-low-volatility-funds-are-doing] that low volatility funds were up USD15.1 billion in the first seven months of the year and easily proving the most popular. MPI quotes BlackRock’s Holly Framsted who says minimum volatility funds the `fastest growing’ smart beta segment.

However, MPI warns that critics have cautioned against low volatility strategies citing sector concentration, rate sensitivity and potential crowding risks. They write that the prospect of rate rises, currently, may be contributing to withdrawals from low volatility funds after a long period of inflows.

“Low volatility funds seek to take advantage of the `low volatility anomaly’ – the empirical observation that lower risk (as measured by beta or volatility) securities outperform their higher volatility counterparts,” the firm writes.

MPI’s paper researches the low volatility sector and the indexes on which it is based and arrives at the conclusion that implications for investors from the research are that low volatility investing is an active strategy with active sector and factor tilts. The firm writes that while these tilts do change over time, they appear persistent over moderately long periods, changing rapidly only with regime changes.

On a longer term basis, low volatility tends to deliver on the only characteristic it truly targets, which is a lower standard deviation of returns than its parent index, albeit with high sector concentration and higher turnover, MPI says.

“As a component of a multi-factor portfolio, the strategy’s exposures to other targeted factors should be a major consideration. While significant interest rate exposure might be unique to this particular strategy, the quality and momentum factor exposures could possibly result in an unintentional `doubling down’ of factors in a multi-factor portfolio.”

More research, this time from Lyxor Asset Management compared the performance of European domiciled active funds with that of their benchmarks.

This research looked at the performance of 3,740 active funds representing EUR1.2 trillion in AUM compared to their traditional benchmarks over a period of 10 years, Lyxor found that European domiciled active funds had a more positive year in 2015, with an average of 47 per cent outperforming their benchmarks, significantly more than 2014 where just 25 per cent outperformed on average

Looking at the source of this outperformance, Lyxor found a significant part could be attributed to specific risk factors. These `risk factors’ describe stocks that exhibit the same attributes or behaviours. Lyxor has identified five key risk factors: Low Size, Value, Quality, Low Beta and Momentum, which together account for 90 per cent of portfolio returns.

The research revealed that European active fund managers were overweight Low Beta, Momentum and Quality Factors in 2015, which all outperformed benchmarks. Another aspect of Lyxor’s research compared active fund performance with Minimum Variance smart beta indices, which are designed to reduce portfolio volatility. Here the results were even more compelling: whereas 72 per cent of active funds in the Europe category outperformed a traditional benchmark in 2015, only 14 per cent outperformed the smart beta index.

The firm writes that these findings demonstrate the increasing role played by smart beta strategies that are based on rules that do not rely on market capitalisation, as an indispensable pillar of investor portfolio.

http://www.institutionalassetmanager.co.uk/2016/11/23/246064/factoring-smart-approach

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