Smart beta, factor investing and risk premia

smart beta

What is the difference between passive and active portfolio management?

The objective of Passive portfolio management is to replicate the performance of an index.  The weight of each underlying asset in traditional indexes is determined by market capitalization. Investors who implement active management strategies try to outperform a specific index, such as the S&P 500 or the Stoxx 600, through stock picking.

Historically, active management returns were explained by the Beta (market risk) and the Alpha (representing manager skill).  Currently, academic research has identified factors explaining returns: the Beta can be divided into Traditional Beta and Smart Beta (Long-only enhanced risk premia).

Factor investing is nothing new; it has been well supported by academic research during the last decades. The main factors are:

  • Low beta (1972) è Buying Low beta or Low Volatility stocks
  • Size / Liquidity (1993) è Buying Small caps
  • Value (1993) è Buying Cheap stocks (Price / book value, Price Earning ratio…)
  • Momentum (1993) è Buying past gaining stocks
  • Quality (2000) è Buying high quality stocks

 

What are the new trends?

There are clear trends from active to passive, and from traditional beta to “smarter” beta. Investors are looking to enhance returns, without incurring excessive cost (active fund management fees) or risk.

Each factor has generated positive returns over the long term even with different drivers and characteristics. Their correlation is low. We can construct new optimized indexes based on these factors. We call them Smart Beta index, Alternative Beta or Scientific Beta. On the whole, Smart Beta is defined as an investment strategy that adopts an index-based investment strategy that is not traditionally market cap–weighted (i.e. fundamentally weighted, equal-weighted, factor-weighted, optimized, etc.). It is not only about academic factors.

Smart-beta exchange-traded funds are growing slightly faster than ETFs as a whole, with assets ballooning to $505 billion — about a fifth of the industry total — from $74 billion a decade ago. As investors look to grow the returns of market capitalization-weighted indices, it makes sense to consider the above factors. However, the challenge is to capture these factors efficiently.

The last survey of global institutional asset owners’ adoption and evaluation of smart beta indexing realized by FTSE Russell, indicates that 46% of the participants are using Smart Beta in their allocation.  Risk reduction, return enhancement and improving diversification persist as primary objectives for the use of smart beta. Cost saving continues to increase in importance, indicating that smart beta is increasingly being used instead of active strategies. The authors of this research see strong growth prospects in the usage of multifactor combination strategies and the application of ESG considerations to smart beta. The most popular single-factor smart beta strategies are low volatility and value.

 

From Smart Beta to Risk Premia…

Academic research also shows that Alpha, delivered by active or Hedge Fund managers, can be divided into Alternative Risk Premia (Long/short uncorrelated risk premia) and real Alpha.

The effectiveness of Alternative Risk Premia is now widely-accepted even though it has led to the proliferation of “factors” and products. Different factors can be applied to all asset classes (equity, fixed income, currencies and commodities).

To conclude, the first generation of smart beta strategies became the competitors of long-only active managers. The second generation will probably compete with absolute return strategies or hedge fund by capturing Risk Premia. In this universe, you can find a wide range of products and strategies. The dispersion of performance is also wide. As for absolute return strategies, the understanding and the selection of Alternative Risk Premia will become a key element in generating long term positive returns.

 

TC Stratégie Financière / Thierry Crovetto & Pierre-Yves Dittlot.

www.tcsf.mccontact@tcsf.mc

TC Stratégie Financière SAM is an asset management company based in Monaco.  As a firm that is closely-connected to the academic field, our approach focuses on research leading to both asset allocation advice and more complex quantitative models. From advisory mandates to “white label investment products”, we seek to maximize investment performance while minimizing drawdown.

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