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Why is smart beta a true revolution?

So what is “smart beta”? A mere revolt against traditional indices? No, Sir, it’s a true revolution – the factor investing revolution. The questioning of allegiance to traditional indices, which until now were used broadly despite some serious drawbacks, has only just begun, but the stakes are already high and this could bring structural and long-lasting changes to the way investors make strategic allocations.

Article also available in : English EN | français FR

So what is “smart beta”? A mere revolt against traditional indices? No, Sir, it’s a true revolution – the factor investing revolution. The questioning of allegiance to traditional indices, which until now were used broadly despite some serious drawbacks, has only just begun, but the stakes are already high and this could bring structural and long-lasting changes to the way investors make strategic allocations.

The seeds of revolution

It all started after a major crisis of confidence in 2008. True, smart beta was at first, and above all, a marketing innovation, a reassuring turn of phrase that capitalised on the more than 10 years of expansion in index management and exchange-traded funds (ETFs), driven by a search for greater transparency and more competitive pricing. Smart beta also took up the already well-worn theme of the inadequacies associated with traditional market cap-weighted indices. Using traditional indices in investment vehicles in certain market conditions had resulted in heavy overexposure to only a few sectors (for example, to telecommunication services stocks during the 1998-2000 TMT bubble).

Smart beta’s simplicity and efficiency naturally caught on with index producers and ETFs in the face of cut-throat competition. They grabbed onto this approach as a way to stand out from the crowd. And yet, in theory, these strategies are not especially “passive” or particularly suited to a short-term investment horizon. On the contrary, investments that disregard market cap-weighted indices tend to have greater portfolio turnover. And the instantaneous liquidity provided by an ETF is less crucial when one’s focus is on long-term performances factors.

From revolt to revolution

As we previously explained in our article entitled “Demystifying Equity Risk-Based Strategies” [1] , published in 2012, there is nothing magical about the returns of these strategies. They are driven by well-known outperformance factors such as the “low-volatility anomaly” phenomenon, which THEAM has been instrumental in popularising. Research [2] seems to show that a portfolio consisting of low-volatility stocks could offer greater risk-adjusted returns over the long term than more risky equities.

Outperformance is not the only factor an investor could focus on. It is also possible to develop strategies based on themes such as “value” (targeting discounted stocks), “momentum” (investing in stocks that have recently outperformed), quality of financial fundamentals, etc. Keep in mind that each of these performance factors also carries a specific risk. There are various methods to transform a factor into a strategy, balancing the quest for returns, investment constraints and the risks inherent in the factor.

For example, the “value” factor, which consists of buying inexpensive stocks based on the conviction that they will move up, can be used in various company metrics based on long-only positions, or a combination of long positions with short positions on stocks deemed overpriced (long-short). Relative to a benchmark index, it can result in over- or underexposure of the stocks in question. Stocks can be weighted on the basis of how expensive or liquid they are, or based on their market cap. Risk, whether in absolute terms or relative to an index, can potentially be limited (or not) through a filter or an optimisation. These nuances are contributing to the current diversity in smart beta, which, like another revolution, has its share of jacobins, cordeliers and sans-culottes.

Resistance to change

Some investors may be confused by this plethora of implementation methods. Is this revolution destined for failure given that it is not unitary? Some people seem to think so, pointing to the steep growth in assets under management of smart beta funds in arguing that this could end up wiping out alpha. But regarding smart beta as a passing fad would be to ignore the fact that the overwhelming majority of managed assets are still indexed to traditional indices and will probably remain so for several more decades. Moreover, the very diversity of approaches available to investors protects them from the kind of uniformity that could potentially destroy value.

Once you accept the validity of smart beta, there is still the matter of combination. How should each factor or strategy be weighted? What benchmark should be used? How can these strategies be implemented in an overall allocation? For now, two schools of thought appear to have emerged: 1) proponents of indexed management argue for the use of a range from the same supplier to ensure consistency in the use of various factors; and 2) consultants argue for an approach involving theme-based sub-asset classes, so that risks can be managed and competition can be fostered between different offerings. But each of these visions treats separately the strategies based on various factors, even though their strength comes from their complementarity, which will emerge from the stable alpha created and the overall management of risks.

Waiting for the other shoe to drop?

In June 2013, Raul Leote de Carvalho, co-head of financial engineering at BNP Paribas Investment Partners, came up with a “revolutionary” method for combining several alpha factors within the same portfolio, while separating their constraints. This approach can be used to construct a “multi-smart beta” portfolio, in other words a single portfolio exposed to several systematic alpha factors in proportions set by a risk budget, i.e., the tracking error vs. a starting index. For example, this methodology can be used to develop a strategy targeting a total tracking error of 5% and to allocate 60% of the portfolio to the “low volatility” factor, 20% to the “value” factor, and 20% to the “momentum” factor.

Such an approach offers several advantages compared to a method that would settle for juxtaposing several single-factor smart beta strategies. First, the pooling of constraints reduces the overall cost. Second, risk management is optimised, as it is total risk that is managed and not individual risks likely to offset one another. And third, this methodology makes it possible, ex-post, to attribute performance directly to the true performance factors and, hence, to better understand them.

Of course, such a structuring approach will have repercussions on the portfolio’s overall philosophy, as it will require explaining allocation choices through the prism of risk. But isn’t it precisely the assumption of risk that transforms a revolt into a revolution?

Etienne Vincent , April 2015

Article also available in : English EN | français FR

Footnotes

[1] The white paper “Demystifying Equity Risk-Based Strategies: an Alpha plus Beta description” by Raul Leote de Carvalho, Xiao Lu, Pierre Moulin (all of BNP Paribas Asset Management) was published in The Journal of Portfolio Management, Vol. 38, No. 3, Copyright © 2012, Institutional Investor, Inc.
To be redirected to the website of The Journal of Portfolio Management where, upon completion of an application form, you can access the Journal of Portfolio Management website : Click here

[2] “The Effect of Volatility Changes on the Level of Stock Prices and Subsequent Expected Returns”, by Robert A. Haugen, Eli Talmor, and Walter Torous, The Journal of Finance, May 1991

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