
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.