SWFs Are Hot for Smart Beta: What Does That Mean For Stakeholders?

April 01, 2015 by Loch Adamson

#SWFs Explore Smart Beta Strategies
Alaska's #SWF: "Today's alpha is tomorrow's smart beta"
Norway's #SWF Eyes Smart Beta
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Sovereign wealth funds are exploring and investing in the increasingly popular strategies collectively known as smart beta. Will that boost returns? 

In early December, trustees of the $51.4 billion Alaska Permanent Fund Corp . (APFC) gathered in a fifteenth floor conference room at the Sheraton Anchorage Hotel. Through the expansive windows, staff, advisors and consultants had a stunning view: Alaska’s most populous city was spread out below them, with mountains looming majestically in the distance.  

Their focus that day, though, was not snow-capped peaks. One key item for APFC CIO Jay Willoughby: smart beta. The strategy, whose very definition is widely debated by academics and industry practitioners, strives to outperform traditional capitalization-weighted indexes, like the Standard & Poor’s 500 Index of U.S. stocks, by tilting portfolios to emphasize securities that have specific characteristics, "risk factors" in Wall Street argot, that make them more likely to generate long-term superior performance — or else display lower volatility.  

This often means putting money into cheaper stocks, smaller ones, those with less debt, for example. Or a combination of the above. And it oftentimes means jettisoning market-capitalization as a measure of how much stock, and most smart-beta is equity focused,  to hold.  

Willoughby, who joined APFC in 2011 from hedge fund Ironbound Capital Management, proposed the fund shift $1 billion from its equity portfolio into smart beta — which also goes by such monikers as alternative beta, strategic beta, factor-based investing and worst of all, "quantamental" indexing. The fund already had a big chunk of its money, nearly $5 billion worth, invested in smart-beta or related strategies.

"Today’s alpha is tomorrow’s smart beta," Willoughby told the meeting, according to people who were there. And he is by no means alone in his assessment.  

Analyzing Strategies

Sovereign wealth funds, along with other institutional investors, are increasingly eager to shovel billions into smart-beta strategies or at least are considering doing so. "It’s large and it’s growing very rapidly but it’s still a relatively small part of the investing universe," says John West, managing director and head of client strategies at Research Affiliates, the Newport Beach, California-based firm credited with popularizing smart beta. "We’re in the second inning of the smart beta baseball game and there are seven more to go."

MSCI , the New York-based index and research firm, estimates assets utilizing smart beta strategies have grown from a mere rounding error in 2005 to $20 billion in 2010 and to roughly $500 billion today. More sovereign wealth funds are wading into the strategy, even if they aren’t trumpeting their conversion as a major shift in strategy.

Norges Bank Investment Management (NBIM), for example, which oversees Norway’s $860.8 billion Government Pension Fund Global has made a strategic decision to tilt part of its equity allocation to smart beta-style strategies, according a person familiar with the firm’s investment policy.  Spokesperson Marthe Skaar did not confirm such a change, but in an e-mail said NBIM analyzes smart beta strategies.  

"We have researched a range of systematic risk factor strategies, and published discussions notes on these themes," she said, adding that NBIM measures the fund’s exposure to such factors. "There is no clear definition of 'smart beta’, but in the broadest interpretation you could argue that it is all systematic investment strategies that deviate from a market cap weighting scheme," she said.  

Lowering Volatility  

New Zealand Superannuation Fund CIO Matt Whineray told Sovereign Wealth Center this month in an interview that the $21.5 billion state-owned investor was exploring smart beta. "We’ve been doing quite a lot of work on that and thinking about those types of exposures, which are really just different ways of cutting up your market exposures, particularly using value and low-volatility approaches," he said.

Other state-owned investors are on the smart beta chase too: A source close to the Petroleum Fund of Timor-Leste told the Sovereign Wealth Center that the state-owned investor, with $16.6 billion in assets, is exploring smart beta investments, considering allocating 5 percent of its portfolio, or $800 million, to an exchange traded fund or other external manager.  

Other sovereign wealth funds and their ilk, including the Alberta Investment Management Corp , which oversees the $15.5 billion Alberta Heritage Savings Trust Fund , the $589 billion Abu Dhabi Investment Authority and Singapore’s $315 billion GIC , did not return emailed questions as to whether they were contemplating or already utilizing smart beta strategies.  

In a nutshell, smart beta strategies weight holdings not by market capitalization but by other attributes that research has suggested heightens returns — the set may be sales, earnings, dividends or a combination of these and other characteristics. Sophisticated versions try and compensate to avoid overweighting, say, a particular industry or creating a portfolio resulting in correlations that make it riskier.  

The lure of smart beta is that in years of back-tested studies, the strategies over long stretches beat the classic market capitalization-weighted benchmarks, like the S&P 500, which critics say overweight the priciest stocks. Or they can experience lower volatility.

Active Managers

That, however, is a key problem: back-tested data doesn’t deal with real world market realities — the market impact of price moves and other friction that can reduce returns over time. Since turnover is usually higher for smart beta portfolios than traditional market-weighted indexes, embedded costs like the effect of stock price movements are higher on returns as are brokerage fees.

Outside managers typically charge somewhat more to implement such strategies compared to plain indexing. If weighting a portfolio to small capitalization stocks produces outsized gains, perhaps as a result of the extra volatility of such equities, once investors pile in the extra gain over an index may dissipate, critics argue.  

"Any time there’s a lot of assets chasing a strategy you run the risk of the profit being arbitraged away," says Alex Bryan, an analyst at Morningstar , the Chicago-based financial publisher, who focuses on passive strategies. Small cap stocks bested their large cap counterparts for years, he points out, displaying strong outperformance tendencies. "I’d be surprised if it is as strong as it was years ago," he says.

MSCI research shows that the amount of assets can grow substantially and still deliver extra return or lower volatility. "What we found was even at fairly high asset levels the factors don’t go away," says managing director Brett Hammond, head of multi-asset applied research at MSCI. "Running multi—hundred billion dollar portfolios, the effects remain. There are $30 trillion of equities traded."

Because research by MSCI and other firms shows that the benefits of smart beta can contribute meaningfully to portfolio performance over the long term, that could be bad news for indexers, active managers and hedge funds. Though it may be difficult or impossible to meet the low costs of an index fund, because most smart beta strategies are based on rules, they are relatively cheap to implement with a computer algorithm — possibly without the help of an external manager.

Counting Fees

Portfolio turnover is higher, but can be limited with a variety of tools so that expenses may be relatively easy to overcome if they amount to, say, 30 basis points versus 5 to 10 for standard index funds.

The real damage could be done to active managers. These stock-pickers strive to generate returns greater than the index with fees of, say, 90 basis points for a traditional asset manager. And they have have on average been notably poor at doing so, especially in recent years.  

Alpha-hungry hedge funds typically charge a 2 percent management fee and 20 percent of profits above a hurdle rate, the so-called carried interest. Average hedge fund performance too has been lackluster in recent years despite the high fees.

As for APFC, it’s hardly a neophyte in the smart beta arena. The fund began investing in what it calls quasi-index strategies nearly 10 years ago, allocating money to Austin, Texas-based Dimensional Fund Advisors , and using benchmarks like Bank of New York Mellon Corp. ’s FTSE RAFI US 1000 Index — which harnesses algorithms to apportion assets to stocks based on such characteristics as sales, cash flow, dividends and book value. About 8 percent of the the fund’s $20.4 billion stock portfolio was allocated to such smart beta or other quasi-index strategies as of June 2014.

The discussion in December touched on whether smart beta fees justified the returns, according to published minutes of the meeting. Willoughby suggested a standalone account was one possibility, but also said that APFC’s size would allow it to negotiate favorable fees.

Contrarian Rewards

The APFC trustees agreed to study the matter. Last month New York-based BlackRock , the asset management giant with big indexed portfolios which is also a major smart beta investor, made an educational presentation to the fund’s trustees. No decision as to whether to allocate the additional $1 billion, or to who, has been made, according to an APFC spokesperson.  

Scale matters in other ways. NZ Super’s Whineray said big investors, if they choose to allocate to smart beta strategies, shouldn’t be parsimonious.

"If you decide that smart strategies fit you, you should really be in them in a serious fashion," he said. "I see a few people do smart beta and they put 2 percent of their portfolio in value and you think 'what’s the point of that?’. You’ll just be creating a lot of administrative and internal monitoring for something that’s not going to make a great deal of difference on your portfolio."

The long-term time horizons of sovereign wealth funds should work in their favor too, since many smart beta strategies are cyclical. Value and growth stocks, for example, go in and out of style as do small-capitalization stocks versus large ones — often for reasonable economic or market-related reasons. In the early 2000s, high quality stocks — those with low debt and consistent earnings — underperformed for several years.  

The ultimate lesson of smart beta investing strategies may simply be having the conviction to tack against current investment fashions. Being a contrarian, after all, can generate outsized rewards.

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