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Smart Beta for improving risk adjusted returns

 James Bevan, CIO, CCLA IM

James Bevn, CIO, CCLA IM

16-17 September 2014 | Millennium Hotel London Mayfair

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Attractions of Smart Beta as an alternative to active and passive investments

•Equity investors like the idea of outperforming but recognise that being consistently ahead is very challenging – and active fees often seem to reward the manager and not the risk taker

•Passive management has grown in popularity because investors recognise that a properly specified index is hard to beat, and minimising cost-leakage is really important – but investors do reckon that they can do better

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Attractions of Smart Beta as an alternative to active and passive investments

•Very large funds typically hire a number of active managers, but this practice can quickly become self-defeating, as the effects of the managers’ pure stock selection skills will diversify away very rapidly, and the fund will effectively be left with a very expensive index fund overlaid with a small number of Style tilts

•A 2009 performance evaluation study done for the Norwegian sovereign wealth fund came to the conclusion that the fund would be better off simply building a set of Style Factor portfolios themselves

•In recent years, this conclusion has resulted in the enormous growth of ‘Smart Beta’ funds and ETFs

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Attractions of Smart Beta as an alternative to active and passive investments

•Finance academics and practitioners have long since identified a number of Style Factors that out-perform the broad equity market, on average, over timeExamples include Value, Growth, Momentum, Quality

•The underlying idea is that each of these Style Factors has a corresponding factor risk premium, or return, that can be harvested for investors

•Smart Beta funds purport to deliver these returns to investors: they can be thought of as index funds with Style tilts; to a quant, they are Factor portfolios

•A recent internet search in the US market found over 40 Value indices, and 28 Value ETFs

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Attractions of Smart Beta as an alternative to active and passive investments

•The idea of Smart Beta funds makes a lot of sense

•Their basic purpose is to deliver Style Factor returns to investors as cheaply and easily as possible

Return = Risk free + beta + alpha

Type of risk: SystematicUnsystematic

Opportunity set: Limited ExtensiveRange of return/risk: Low HighCorrelations: High LowDifficulty: Low HighCost: Cheap ExpensiveCertainty of positive return: High over time None

Time horizon is important – and skill is rare

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Attractions of Smart Beta as an alternative to active and passive investments

•One of things that many investors have recognised is that if you can explain an ‘active bet’, then it almost ceases to be an alpha

•Portfolios can therefore be seen to contain exposure to many factors which masquerade as alpha, but which should be viewed, treated and invoiced as beta

•The disturbing reality is that disciplined investors can on paper, with enough time, beat indices quite easily

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Attractions of Smart Beta as an alternative to active and passive investments

Virtually all ‘price indifferent’ strategies outperform

Investment Strategy Breaking the

link between price and weight

Rebalance

Risk Weighted Strategies Fundamental Strategies Smart beta Random monkeys Cap weighting

Yet many smart beta products and strategies under-deliver

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Comparing smart-beta strategies

1. All non-cap-weighted strategies have value and small size tilts

2. Many smart beta strategies suffer from high implementation costs

3. Issues for investors:

-Time horizon

-Turnover and trading costs

-Economic representation -Taking only bets that make sense-Avoiding unintended, unwarranted, unwanted risks

-Capacity/liquidity

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Comparing smart beta strategies

Scalability really matters

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Comparing smart-beta strategies

•Apart from cost leakage, many ‘Smart Beta’ funds don’t deliver - They have a Style tilt, but don’t give the Style return, - They usually have more risk than necessary, and significant

exposures to other factors

•We can trace the problem to poor portfolio construction- Weightings to stocks are often arbitrary and are not

designed to capture the Style Factor premia- With no effort to optimise factor exposures, performance

ends up being driven by exposure to market, industry and other factors

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Comparing smart-beta strategies

•It may be that the marketing imperative to have a simple story is more important than delivering an efficient Style tilt

•All is not lost – it’s possible to build Smart Portfolios that can do a much better job of delivering the Style Factor return, with lower overall risk, and much less exposure to other factors

•Managers can trade off each stock’s (Style-related) expected return against its risk

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Comparing smart-beta strategies

• Markowitz proposed that the most efficient way to manage portfolios was to have holdings whose contribution to portfolio expected return matched their contribution to risk

• This idea was first published in 1952, and no-one has yet come up with a better idea

• However most Smart Beta funds don’t do this

• In fact, their construction method often disregards risk completely, except for having lots of holdings, which is presumed to give greater diversification

• This makes them inefficient – therefore it should be easy to improve their performance

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Comparing smart-beta strategiesRisks that people think that they can avoid – ‘Low vol’ and ‘min vol’

•The CAPM identifies ‘risk’ as the principal driver of premium returns – yet for extended periods, there seems to have been a return premium from seeking least risk•This in part an example of how easy it is to beat a cap weighted index •If we look at the data, we can discern a clear link between the returns to low vol. and the movement in rates and bond yields – which have been in a downtrend since the early 1980s.•If the trend in bond yields turns up, low vol. may underperform.

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Comparing smart-beta strategiesRisks that people often don’t recognise – Environmental, social and governance (ESG) factors

•There are systematic risk factors that are not captured in conventional P&L and balance sheet analyses

•Governance risks relate to audit, board structure and function and the relationship between boards and shareholders and dominant and minority shareholders. Exclusions can reduce risk

•Social and environmental risk factors relate primarily to mis-costed activities

•‘Sustainability’ will be a core equity valuation factor for all long term focused strategies.

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How should institutional investors set metrics for manager performance with these strategies, and asset

returns against costs?

•Institutional investors should be focused on–Whether they get what they need relative to their liabilities–Whether they get what they’re expecting and deserve from exposure to the selected ‘smart beta’–Net returns–What risks they’re running, whether these are acceptable, and how they can be managed–Long only vs. long/short with leverage is a big issue

•Combining smart betas can significantly reduce ‘risk’, but there needs to be clear focus on diversification opportunities and realities

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How should institutional investors set metrics for manager performance with these strategies, and asset

returns against costs?

•It’s really important to determine how performance will be considered and who owns what accountability

•Understanding how returns have been achieved is as important as understanding what the returns are

–Investors need to do a lot of homework before starting a mandate and combining mandates–Agreeing what’s to be measured can be (surprisingly) tricky–Portfolio construction needs to be robust–Risk needs to be clearly in focus

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How should institutional investors set metrics for manager performance with these strategies, and asset

returns against costs?

•It is not possible to measure Style Factor returns directly. In practice, they are estimated, either by creating Factor-Mimicking Portfolios (FMPs), or by running cross-sectional regressions on stock returns •The difficulty with using FMPs lies in trying to make the portfolios independent of other factor effects

•On the other hand, using cross-sectional regressions means the Style Factor returns will be conditioned on all the other factors included in the regression

•Style Factor returns are usually conditioned on each other; however, they are often conditioned on market, industry or currency factors as well

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How should institutional investors set metrics for manager performance with these strategies, and asset

returns against costs?

•Investors should look for an optimal portfolio construction process to create an efficient Style Factor portfolio

•Optimisers are notoriously prone to error maximisation – to be useful, we need to have confidence in return and risk estimates

•With Style Factor portfolios, expected returns can be a sensitivity to the Style factor – we hope that the Style Factor premium is positive, but at least we are sure about the stock beta to the factor.

•Using Style betas as the expected return proxy ensures that the portfolios have a significant Style Factor tilt

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How should institutional investors set metrics for manager performance with these strategies, and asset

returns against costs?

•We also need to be confident about the risk numbers

•In practice, this means that we need to be sure that the risk model has done a good job of identifying the sensitivities of each stock to the various factors, and of capturing its systematic common factor risks

•We can filter the candidate universe to screen out stocks with low R-Squareds

•We can filter out very high risk stocks as their risk characteristics may be biased estimates of true risk, and may appear to offer (spurious) diversification

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How should institutional investors set metrics for manager performance with these strategies, and asset

returns against costs?

•Liquidity control: it’s wise to set a maximum that can be bought of any stock, expressed as a limit on the shares held as a percentage of trade volumes

•There needs to be shared view on scalability and investors need to keep a watchful eye on ‘shelf life’

•Rebalancing: there need to be triggers for rebalancing

•Cost control: in deciding whether to trade or not there need to be explicit assumptions on implementation costs and fees. Total cost leakage needs to be in focus

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Smart beta: conclusions

•Smart Beta offers plenty of attractions as an alternative to active and passive investments

•When comparing smart beta offers, we need to focus on what, why, and how

•We need particular focus on expected net returns, scalability, cost and risk