Note to user: Replace this image with your own. Right click on this Placeholder box Replace image Select image and click ‘Resize image to fit in placeholder’)

APPLIED FINANCE CENTREFaculty of Business and Economics

Smart Beta: Why the popularity and what’s under the bonnet?

SLAVA PLATKOVPORTFOLIO MANAGER, DIMENSIONAL FUND ADVISORS

1

Sydney CBD, 27 February 2018

Agenda

• What is Smart Beta?• Why the popularity?• What’s under the bonnet?• Summary

What is Smart Beta?

Low cost alpha

Versions of indexing

…use other factors to weight stocks in the portfolio. Such factors are often fundamental in nature, such as sales and dividends, but can also be market-based, such as volatility.

…seek to exploit these market inefficiencies by anchoring on factors other than price (S&P Dow Jones)

…offer the benefits of passive strategies combined with some of the advantages of active ones, placing it at the intersection of efficient-market hypothesis and classic value investing

…can you pay the low fees of a passive index fund but enjoy higher returns than the typical index fund? (WSJ)

…exploit these market inefficiencies by anchoring on factors other than price (RAFI)

…an attempt to avoid concentration in mega-caps led to the next innovation in index investing: smart beta

What is Smart Beta?

What is Beta?

PASSIVE

Market cap based

PRICE COST EFFECTIVE DIVERSIFIEDTRANSPARENT

The power of staying invested

6

INVESTORS GET COMPENSATED FOR TAKING ON RISK

$10

$22

$20

$30

Feb-

85A

ug-8

5Fe

b-86

Aug

-86

Feb-

87A

ug-8

7Fe

b-88

Aug

-88

Feb-

89A

ug-8

9Fe

b-90

Aug

-90

Feb-

91A

ug-9

1Fe

b-92

Aug

-92

Feb-

93A

ug-9

3Fe

b-94

Aug

-94

Feb-

95A

ug-9

5Fe

b-96

Aug

-96

Feb-

97A

ug-9

7Fe

b-98

Aug

-98

Feb-

99A

ug-9

9Fe

b-00

Aug

-00

Feb-

01A

ug-0

1Fe

b-02

Aug

-02

Feb-

03A

ug-0

3Fe

b-04

Aug

-04

Feb-

05A

ug-0

5Fe

b-06

Aug

-06

Feb-

07A

ug-0

7Fe

b-08

Aug

-08

Feb-

09A

ug-0

9Fe

b-10

Aug

-10

Feb-

11A

ug-1

1Fe

b-12

Aug

-12

Feb-

13A

ug-1

3Fe

b-14

Aug

-14

Feb-

15A

ug-1

5Fe

b-16

Aug

-16

Feb-

17A

ug-1

7

Growth of $1 (AUD)

Bloomberg AusBond Bank Bill IndexCiti WGBI ex Australia (hedged to AUD)MSCI World ex Australia IndexS&P/ASX 300 Index

Pioneering Index Investing

7

VANGUARD, THE 2ND LARGEST MANAGER GLOBALLY

Vanguard assets under management1975 - 2015

$3.5 T

3.0 T

2.5 T

2.0 T

1.5 T

1.0 T

500 B

DEC 75 DEC 85 DEC 95 DEC 05 DEC 15

$3.4 trillion

Smart Beta is Active

ACTIVE

Portfolio Weight ≠Market Weight

Selection Weighting

Stock/Bond Pickers Quant/Black BoxFactor-based Systematic NOT Tracking an Index

Factor-based Systematic Tracking an Index

What is Smart Beta?

Smart beta strategies are designed to add value by systematically weighting, and rebalancing portfolio holdings on the basis of factors or characteristics other than market capitalisation

Smart Beta Products

FUNDStrack indices

not based on market

cap

SMART BETA

FUNDSweights

systematically different to market cap

ETFstrack indices

not based on market

cap

Percentage of Assets in Strategies

11

VALUE, GROWTH AND DIVIDEND MOST POPULAR

Value , 24

Dividend, 24

Growth , 23

Multi-Factor , 7

Low Vol, 6

Equal Weighted, 6

Fundamental, 3

Fixed, 2

Momentum , 2

Commodity, 1

Quality , 1

Other, 2

Source: Morningstar Direct, US Strategic Beta ETPs Data as of 6/30/2017

Largest Smart Beta Managers

12Source: Morningstar Direct, Morningstar Research. Data as of 6/30/16.

Why the popularity?

Growth in Smart Beta Funds (USD billions)

Source: Morningstar. Smart beta funds are all US equity funds and ETFs classified as “Strategic Beta” by Morningstar.

TOTAL NET ASSETS IN SMART BETA FUNDS (2000–2016)

0

100

200

300

400

500

600

2000 2004 2008 2012 2016

US

D $

b

Why the popularity?

Traditional active management has failed to deliver

Competitive Markets

High Fees

Suboptimal Implementation

Competition Makes it Difficult to Outguess the Market

Source: World Federation of Exchanges. Global electronic order book figures gathered from the 60 WFE member exchanges.

MARKETS INTEGRATE THE COMBINED KNOWLEDGE OF ALL PARTICIPANTS

82.7 millionAverage Number of World Equity Daily Trades

$478.4 BillionAverage Dollar Volume of World Equity Daily Trades

Many Paths to Price Discovery

1.1 Million OptionsAverage number of put and call

contracts traded daily

105 Million SharesAverage Daily Trade Volume of SPY

$179.9 Billion Futures

Average value of equityfutures traded daily

1,131IPOs

3,509Offerings

Seasoned Equity Offerings

3,544Buybacks

Share RepurchasePrograms

The supply and demand of securities is determined in many markets and by many participants.

Options, SPY trade volume, futures, and corporate action data are from Bloomberg L.P. Option contract volume is the sum of the 2016 daily average put and call volume of options on the S&P 500, Russell 2000, MSCI EAFE Index, and MSCI EM Index. Equity futures volume is equal to total 2016 futures volume traded divided by 252, where annual volume traded is estimated as the sum of monthly volume times month end contract value for S&P 500 Mini futures, Russell 2000 Mini futures, MSCI EAFE Mini futures, and MSCI EM Mini futures. IPO, seasoned equity offering, and share repurchase data are based on Bloomberg corporate actions data and include countries which are eligible for Dimensional investment. This is for illustrative purposes only. Not representative of holdings of any Dimensional Strategy or Portfolio.

Few Equity Mutual Funds Have Survived and Outperformed

Analysis performed by Dimensional Fund Advisors. The sample includes funds at the beginning of the five-, 10-, and 15-year periods ending 31 December 2016. The number of funds as of the beginning of each sample time period is indicated next to the period label. Survivors are funds that had returns for every month in the sample period. Winners are funds that survived and outperformed their respective Morningstar category benchmark over the period. US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago. Past performance is no guarantee of future results. See Data Appendix for more information.

AS OF 31 DECEMBER 2016

5 Years2,863 funds at beginning

79% Survive

29%Outperform

10 Years2,944 funds at beginning

58% Survive

21%Outperform

15 Years2,587 funds at beginning

48% Survive

17%Outperform

Few Fixed Interest Mutual FundsHave Survived and Outperformed

Analysis performed by Dimensional Fund Advisors. The sample includes funds at the beginning of the five-, 10-, and 15-year periods ending 31 December 2016. The number of funds as of the beginning of each sample time period is indicated next to the period label. Survivors are funds that had returns for every month in the sample period. Winners are funds that survived and outperformed their respective Morningstar category benchmark over the period. US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago. Past performance is no guarantee of future results. See data appendix for more information.

AS OF 31 DECEMBER 2016

5 Years952 funds at beginning

85% Survive

50%Outperform

10 Years1,022 funds at beginning

66% Survive

26%Outperform

15 Years958 funds at beginning

57% Survive

18%Outperform

Other Benefits of Smart Beta

Transparency (ETFs in particular)

Simple & liquid way to gain exposure to

well-known premiums (avoid

dumb beta)

Diversification

Liquidity

Easy to Research

Smart Beta ETFs

What’s under the bonnet?

Explained by Traditional Factors?

23

VALUATION EQUATION

The pricemarket participants are willing to pay depends on…

What a company owns minus what it owes…

Plus, the company’s ability to produce cash flows in the future…

Discounted to the present value at the required rate of return.

Discount Rate

Price = Book Equity(Expected) Future Profits

+

Be sensible and supported by financial economics

Traditional Factors

24

SIZE, VALUE AND PROFITABILITY

All figures represent annualised compound returns (%) in US dollars, with the exception of the Australian stock returns, which are in Australian dollars. Profitability is measured as operating income before depreciation and amortisationminus interest expense scaled by book. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. S&P data copyright 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data copyright MSCI 2018, all rights reserved.*The calculation methodology applied from 1975 for the US Small Cap Index, 1982 for the Australia Small Cap Index, and from 1994 for the other Dimensional Small Cap Indices, was amended (in 2014) to include profitability as a factor in selecting securities for inclusion in the indices. See "Index Descriptions" in the appendix for descriptions of Dimensional and Fama/French index data. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.

16.2510.07

10.826.88

Rela

tive

Pric

ePr

ofita

bilit

ySi

ze

AUSTRALIA STOCKS

SMALL* LARGE

HIGH

1974–2017

LOW HIGH

LOW

1975–2017

1982–2017

13.89 11.96

Dimensional Australia HighProfitability Index

Dimensional Australia Low Profitability Index

Fama/French Australia Growth Index

Fama/French Australia Value Index

12.16 9.87

12.979.54

12.468.35

HIGH

1928–2017

LOW HIGH

LOW

1928–2017

1964–2017

SMALL* LARGE

US STOCKS

Dimensional US HighProfitability Index

Dimensional US Low Profitability Index

Fama/French US Growth Index

Fama/French US Value Index

S&P 500 Index

Dimensional US Small Cap Index

1975–2017

DEVELOPED EX US MARKETS STOCKS

SMALL* LARGE

LOW HIGH

HIGH LOW

1970-2017

1990–2017

14.799.62

13.968.81

6.952.59

Dimensional International High Profitability Index

Dimensional International Low Profitability Index

Fama/French International Growth Index

Fama/French International Value Index

MSCI World ex USA Index (gross div.)

Dimensional Intl. Small Cap Index

1996–2017

EMERGING MARKETS STOCKS

SMALL* LARGE

LOW HIGH

HIGH LOW

1989–2017

1989–2017

12.23 10.47

13.6010.19

9.354.00

Dimensional Emerging Markets High Profitability Index

Dimensional Emerging Markets Low Profitability Index

Fama/French Emerging Markets Growth Index

Fama/French Emerging Markets Value Index

MSCI Emerging Markets Index (gross div.)

Dimensional EmergingMarkets Small Cap Index

MSCI AustraliaIndex (gross div.)

Dimensional Australia Small Cap Index

Low Volatility

25

PORTFOLIO WEIGHTS BASED ON VOLATILITY OR BETA

Low Volatility

26

PORTFOLIO WEIGHTS BASED ON VOLATILITY OR BETA

The volatility sorted portfolios in Exhibits 4–5 each contain 20% of market capitalization and are formed by sorting stocks on market beta. Securities are weighted by market capitalization, and portfolios are rebalanced annually. Market beta is estimated using daily returns for one year. Returns are regressed on the daily market portfolio’s return with five lags, and the market beta is the sum of the current and lagged slope coefficients.

Low Volatility

27

OTHER VARIATION OF LOW VOLATILITY

Systematic Exposures of Low Volatility Portfolios (Jan 1962 – Dec 2012)

Inverse Volatility Low Beta

Minimum Variance Cap Weighted

Market-wide Value

Alpha (%) 0.08% 0.08% 0.10% 0.02% -0.04%

T-stat (1.85) (1.11) (1.72) (1.83) (-0.88)

Market Beta 0.92 0.73 0.58 0.99 1.07

Size 0.57 -0.16 0.27 -0.07 0.11

Value 0.42 0.27 0.45 0.05 0.60

R-Square 0.95 0.77 0.79 1.00 0.95

Fundamental Index

28

PORTFOLIOS WEIGHTS BASED ON FUNDAMENTALS

The fundamental-weighted strategy in Exhibits 1–3 consists of the largest 1,000 securities, weighted proportional to their current book equity and the five-year average dividends, book equity, sales, and cash flows. The large/large value blend in Exhibit 3 comprises 75% large value, represented by the Dimensional US Large Cap Value Index, and 25% large, represented by the Dimensional US Large Cap Equity Index.

Missing Link b/w Price and Portfolios WeightEQUAL WEIGHT SAME SIZE ALLOCATION TO EVERY SECURITY

29

Missing Link b/w Price and Portfolios WeightEQUAL WEIGHT SAME SIZE ALLOCATION TO EVERY SECURITY

30

Russell 3000 Mcap-Wght

Equal-Wght

WA BTM 0.30 0.45

WA MCap ($b) 177,846 11,080

Extreme overweightscan result in excessive turnover and add unnecessary risk to a portfolio.

Weight ratios relative to Russell 1000 Index, as of June 2017

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100% 50 to 100

20 to 50

10 to 20

5 to 10

2 to 5

1 to 2

0 to 1

Equal Weighting

Fund Z

Large Cap Value Portfolio

Minimum Volatility Fund X

Fundamental IndexingFund Y

High Profitability

Portfolio

Large Cap Equity

Portfolio

60652 | 0917

Missing Link b/w Price and Portfolios Weight

Ignoring Price Can Be Costly

32

LEHMAN BROTHERS IN 2008

Quarter Book Value Date Price

Q4 2007 21,395 11/30/2007 62.63

Q1 2008 21,839 2/29/2008 50.99

Q2 2008 19,283 5/31/2008 36.81

Q3 2008 19,283 8/31/2008 15.99

Q4 2008 19,283 11/30/2008 0.01

Prices contain information on market expectations

• Weight = Fundamentals• Fundamentals alone:

― Are stale (even as of the reporting date)

― Do not reflect current news events (market perceived risks are not incorporated)

Index Reconstitution

33

EQUAL-WEIGHTED ADDITIONS RELATIVE TO S&P 500 INDEX (JAN 2000 – DEC 2016)

Multiples oft-40 Volume

Multiples oft-40 Volume

Days from Reconstitution Date Days from Reconstitution Date

Trading Volume Performance

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

35,000,000

-40 -30 -20 -10 0 10 20 30 400%

2%

4%

6%

8%

10%

-40 -30 -20 -10 0 10 20 30 40

Sha

res

Trad

ed

Cum

ulat

ive

Ret

urn

Days From Effective Date Days From Effective Date

In US dollars.Source: Center for Research and Security Prices, University of Chicago, and Standard and Poor’s. For more on index reconstitution see Chen, Noronha, and Singal (2004) [Equity] and Dick-Neilsen (2012) [Fixed Income].Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Index Reconstitution

34

STYLE DRAG (RUSSELL 2000)

As of 31 December, 2016. Monthly data, 2004–2016. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.Indices are not available for direct investment.

Annual Rebalance

95%

90%

85%

JUNE2016

JUNE2014

JUNE2013

JUNE2012

JUNE2010

JUNE2009

JUNE2008

JUNE2007

JUNE2006

JUNE2005

JUNE2004

JUNE2011

JUNE2015

Assets In Small Cap Companies (Bottom 10% Of Market Cap)

Russell 2000 Index

Summary

Summary

• Smart Beta includes strategies that systematically deviate form market cap weights to target various factors

• Same reasons behind growth as those behind Passive, plus perhaps..

• Disappointing experience investing with traditional active managers

• Popularity of ETPs is further turbo-charging the growth in Smart Beta

• The devils is in the detail. Be mindful of Research, Design, Implementation

APPLIED FINANCE CENTREFaculty of Business and Economics

ARE YOU INTERESTED IN OUR UPCOMING TALKS?Visit mafc.mq.edu.au to register for upcoming talks and subscribe to the mailing list

Thank you for attending today’s talk