Large spike in ‘smart beta’ investments

June 16, 2013 4:14 am

Large spike in ‘smart beta’ investments

By Chris Flood

Interest in “advanced” or “smart beta” investment strategies is accelerating, with growing numbers of investors adopting alternative weighting schemes in equity and fixed income portfolios.

Inflows into advanced beta funds reached $15bn in the first three months of 2013, up 45.3 per cent on the same period a year ago. This was the strongest quarterly inflow for three years, according to an analysis by State Street Global Advisors of Morningstar data.Total inflows into advanced beta funds over the past three years was $81.6bn. Most of the growth is being generated via exchange traded funds, which have attracted inflows of $66.2bn over the past three years.

As a result, global assets held in advanced beta strategies grew to $142bn at the end of the first quarter, up from just $58bn at the end of 2010. The number of advanced beta funds available has also expanded dramatically to 457 at the end of March, from around 55 at the start of 2006.

However, data from ETFs and mutual funds underestimate demand.

“Interest in advanced beta via ETFs represents just the tip of the iceberg. There are significantly more assets held by sophisticated institutional investors in separately managed accounts,” said Niall O’Leary, head of portfolio strategy for Emea at State Street Global Advisors.

SSgA alone manages assets of $47.3bn in alternative weightings and low-volatility equity strategies.

“Index-based investing is becoming much more sophisticated,” said Scott Stark, director of Russell Indexes Europe. He says discussions with institutional investors and pension funds over the past year have been dominated by questions about advanced beta.

“The depth of conversations with clients about advanced beta has shifted dramatically. More and more are asking how best to incorporate advanced beta strategies into their portfolios,” added Mr Stark.

Smart beta – old concept, new packaging

Frank Ashe, part-time Associate Professor at the Macquarie University Applied Finance Centre, and a risk management consultant, explains the concept of “smart beta”, and its relevance and application for investors.

Date: June 21, 2013

Tags: Beta, Risk management

What is smart beta?

The concept of smart beta has been around for at least 30 years. Smart beta is really a misnomer, you can only have smart beta if there’s dumb beta. And the dumb beta is the capitalisation-weighted stock market index. That’s the classical idea of what a beta portfolio is. And it’s been known almost since people started looking at modern portfolio theory that the standard capitalisation-weighted stock market indices are not efficient in the mean-variance sense, where you’re looking at a trade-off between market return and the volatility of a portfolio. So they’re not efficient in that sense.

People started looking at alternatives to this years ago. One of the big alternatives came up in the international equity space because it was recognised in the late 1980s is that if you follow the MSCI World Index, you just have far too much invested in Japan because of the Japanese Stock market heading towards 40,000; that was way too high and Japan had way great a   weight in the index. So people started looking at things like GDP Weighting.

People at that time were also looking at minimum variance portfolios; they were looking at other ways of rejigging the capitalisation-weighted benchmarks. What has happened over the last few years as a result, partly, of the global financial crisis, has been a reassessment of how we structure portfolios with respect to the underlying risk factors and stock market exposure; beta in other words, is one of the underlying risk factors.

So do you define beta by market return and risk and alpha by value-add from managers?

Yes, if we take a look at the portfolio return over a long period of time, let’s say on a month-by-month basis, we can ask ourselves the question, what are the main drivers of this? And the typical way to answer that was to use a regression equation.

The basic formula for writing these regression equations is:

The return for the portfolio is

The alpha plus

Beta times the exposure to one market plus

Another beta times the exposure to another market etc, etc

And that’s where the terms “alpha” and “beta” come from.

The beta just represents just how much exposure you have to a particular risk factor which maybe bonds or equity markets. Different equity markets can be used as different exposures, or you can think about international equities as one asset class in which case you’ve got an exposure to international equities. That’s our sense of beta.

Everything that’s not beta is thought of as alpha, clearly as a short hand. That is sometimes talked about as being skill but sometimes it just represents the fact that you haven’t got the right exposures amongst your risk factors and if some of your risk factors themselves are not a good proxy for the underlying risk factor – like how a market capitalisation-based index is not a good factor for exposure to stock markets – then you can get alpha which people think of as being a mark of good investment skill purely as a result that one’s got dumb beta.

Is smart beta something that investors can add via a portfolio manager or are you suggesting that people should use smart beta as their benchmark?

One of the prime examples of smart beta is the RAFI portfolios from Research Affiliates, also called “fundamental indexation”, where the weight given to a particular stock is in some way proportional to how big that company is to the general economy.

The important part about the smart beta ideas in the market is that the weight of the stock of the company in the index is not proportional to its price, not proportional to its capitalisation; it’s proportional to something else.

Other ideas of smart beta are looking at minimum variance portfolios so we put together a portfolio that has minimum volatility, we can have a portfolio which has a bias towards high dividend stocks and there are various other forms as well.

Smart beta will be a value-added tool relative to the standard benchmark and those standard benchmarks are not going to go away because they do represent weight of investment in the industry itself. Now the fact that it should be able to be beaten if I ignore price – that’s a separate thing but because the standard capitalisation-weighted indices do capture the return of the market as a whole, they’re never going to go away as a benchmark.

So smart beta can be used as a way of adding value relative to that benchmark and as a more sophisticated approach than one of the smart beta methodologies can actually be used as your own benchmark that you then try to add value on to. There are a number of managers who are taking that approach. They will take something like RAFI as a benchmark and then apply their own stock-picking skills around that particular benchmark.

What are the trends in smart beta? Are any institutional investors adopting it? Are you seeing it being used in the retail and wealth management industry at all?

There are a number of large institutional investors adopting this and are investing via this mechanism. It’s also available to the retail market in Australia and other countries such as the US, UK and Europe via institutional investors putting that then through their wealth management distribution arms.

Would you recommend retail investors adopt something like this?

One of the advantages of using these products is that they are typically priced at a lower fund management fee than active management. They are not as cheap as a standard index fund but they’re at the half-way point between the two, so from that point of view there is a benefit because as we all know that it’s very hard to demonstrate that managers actually add alpha, and even if lots of managers do add alpha, how can you pick those managers who are going to consistently add alpha?

So as an alternative to a classical index fund these are very worthwhile for retail investors to look at.

One of the things that we see very often in the funds management industry is that an old idea is rebranded as something very new, and one of the reasons for this is to actually charge a premium for it. As mentioned, the whole idea of smart beta has been around for quite a while; there’s nothing much that’s new, so we need to look at the history and beyond the hype.