Sovereign wealth funds are turning to smart beta strategies to
boost returns and lower volatility. Here’s what
managers should know about the potential and perils for the
Enhanced indexes, alternative beta, strategic
beta, or factor-based investing. Whatever the term of art,
smart beta is drawing sovereign wealth funds and other
institutions. MSCI, the New York-based index and
research firm, estimates assets devoted to such strategies have
risen from $20 billion just five years ago to $500 billion
today. The word "bubble" springs to mind.
Relax — but not too much. Smart beta,
after all, is not an asset class, like the internet stocks of
2000 or subprime real estate in 2008. It’s an
investing methodology — moving away from strict
market-capitalization based indexes and using computer
algorithms to allocate stock weightings that incorporate such
characteristics as company sales, profits, cash flow, size,
book value or momentum, known as risk factors or premia in
quant—speak. Academics and money managers are constantly
searching for new ones, but those are among the most
Many smart beta strategies mix a variety of such
factors, seeking to generate returns that either beat standard
market—capitalization indexes like the Standard &
Poor’s 500 Index of big U.S. companies or generate
comparable or better returns with lower volatility. "People are
assuming there’s a free lunch," says John West,
managing director and head of client strategies at Research Affiliates, the Newport Beach,
California firm credited with popularizing smart beta. Better
instead to focus on whether the strategies make intuitive
As Sovereign Wealth Center has reported,
state-owned investors have got in on the act in a major way.
The $51.1 billion
Alaska Permanent Fund Corp. had 8
percent of its equities devoted to smart beta or similar
strategies as of last June and is considering adding another $1
billion. Norway’s $860.8 billion
Government Pension Fund Global
tilts its stock portfolio toward smart beta, according to
people familiar with its strategy. The $72 billion
Korea Investment Corp. is on board,
according to one source familiar with its strategy, and
Sovereign Wealth Center has reported that even the $16.6
Petroleum Fund of Timor-Leste is
considering allocating 5 percent of its assets to smart-beta
In an interview with Sovereign Wealth Center, the
new CIO of Alberta Investment Management Corp.
(AIMCo), Dale MacMaster, who took the reins earlier this year,
said the organization, which oversees the $15.5 billion
Alberta Heritage Savings Trust Fund
sovereign wealth vehicle, is virtually an old hand at smart
beta. "We’re kind of a
quant shop in that regard," MacMaster said last month.
"We’ve been doing this for many years and have
built models that emphasize value, momentum and quality. Those
are factors that have shown to be very important in beating
markets. Sometimes those things are stronger in certain
environments, but in general, over the long run being exposed
to value, momentum and quality has resulted in good returns.
And quite frankly our results show it."
Fueling the smart beta phenomenon are boatloads
of research. One example: A 2013 MSCI study, weighing in at 107
pages, called Harvesting Risk Premia for Large Scale
Portfolios compared returns of a standard
market-capitalization-weighted global stock bogey, the MSCI
World Index, from 1992 through 2012 — two decades
— with benchmarks slightly tilted toward value,
small-cap, low volatility and momentum—driven stocks. To
be clear: these factor—weighted indexes were modestly adjusted
to alter stocks’ weightings in the benchmark, not
totally new or equal-weighted indexes.
Nevertheless, over that 20-year spread, every
risk factor-focused index outperformed the market-weighted
world index. The MSCI World Index returned a gross 7.2 percent
annualized over the 20 years versus 8.4 percent for the
value-tilted benchmark, 7.9 percent for small-cap, 8.2 percent
for low volatility and 8.1 percent for momentum.
The study showed risk was higher in most of the
single-factor biased indexes over the 20-year period (except,
naturally, the low volatility one). But combining the factors
— for example fusing the low volatility-,
small-cap— and value-focused indexes — actually
reduced the risk to below that of the MSCI World Index, while
notching a superior 8.1 percent annualized gross return.
Here’s the rub. These are
back-tested returns, not real life comparisons. The results
assumed portfolios of some $100 million, small potatoes by some
sovereign wealth fund standards. Portfolio turnover at the MSCI
World Index was just 4.3 percent annually on average versus
12.4 percent for the small company index, 12.5 percent for low
volatility, 18.6 percent for the value tilt and a sky high 41
percent for the momentum index. Using blended benchmarks
brought that portfolio turnover to below 13 percent.
What impact will that have on real world returns?
No one knows, although it’s safe to say net
returns after fees would be somewhat lower for smart beta
indexes. "We stress that transaction costs are not explicitly
analyzed here and the actual costs of implementing risk premia
strategies are not easy to estimate," the study says. "Trading
costs and other implementation-related issues, including most
importantly the potential market impact, remain outside the
scope of this study." (Research Affiliates’ FTSE
RAFI U.S. 1000 Index, a smart—beta benchmark, returned 16.6
percent annualized for the five years to February 27 2015
versus 16.3 percent for the FTSE USA All Cap Index.)
Investors have pursued seemingly logical
investment strategies that bit them badly in the face of harsh
market realities in the past. Portfolio insurance in the 1980s,
for example, was theoretically supposed to lock in gains during
a stock market route by automatically selling stock index
futures. Institutions threw caution to the wind, overloading on
stocks, and suffered when the insurance didn’t
work on Black Monday, October 19, 1987 when the S&P 500
fell 22.6 percent in a single session.
More recent events suggest factor-based investing
has its own way of short circuiting. In August 2007, leveraged
quantitative hedge funds, many relying on variations of the
smart-beta strategies, suffered double digit losses in a
week-long span when one began liquidating its positions.
Expensive stocks soared and cheap ones plummeted as the hapless
hedgies tried to exit their positions at the same time. Most
recovered, but others were virtually wiped out.
"Under the Hood"
Sovereign wealth funds entering the smart beta
arena need to perform due diligence. First off, is the smart
beta approach worth the extra money? Some funds, using
complicated multi-factor screens, ultimately end up with what
is functionally the equivalent of, say, a mid-cap index fund
when all is said and done. For example, the PowerShares
Fundamental Pure Small Value Portfolio exchange traded fund
(ETF) carries an expense ratio of 39 basis points, according to
Morningstar, the Chicago-based financial publisher. A
traditional market-cap weighted index like the Vanguard
Small-Cap Value ETF shares cost 9 basis points. Is any likely
difference worth it?
The good news is that smart beta is rules-based. Practitioners
and funds explain their methodologies with admirable clarity.
"There’s a lot of transparency," says Alex Bryan,
an analyst specializing in passive strategies at
. "You know what you’re getting.They follow the
Such transparency means that state-owned
investors can learn about strategies by simply reading the
prospectus. That in itself can shield them from unintended
For example, the PowerShares S&P Low
Volatility Portfolio ETF picks the 100 stocks in the S&P
500 Index with the lowest volatility over the past 12 months
and then weights those with the least volatility highest. As a
result nearly 30 percent of its assets are in either real
estate or utilities, according to re recent data.
There’s nothing wrong with that as long the rest
of the stock portfolio is rebalanced accordingly.
By contrast, the iShares MSCI USA Minimum
Volatility ETF looks for low-volatility stocks too, but uses an
optimizer to keep sector positions within a 5 percent band
around those in the MSCI USA Index, reducing over- or
under-weightings. "Two products with similar names can be doing
very different things," says Bryan. "You have to do a deep dive
on what’s going on under the hood. You have to do
the kind of due diligence as you would with an active
A key decision is whether to implement such
strategies through outside managers or internally with a
dedicated staff. On the surface, since smart-beta is
rule-based, a relatively simple computer algorithm should be
able to handle the job without outside help.
That’s not always the case, given the resources
allocated. "It depends on the capacity of the asset manager,"
says Patrick Schena, Adjunct Assistant Professor and Co-Head of
the Fletcher Network for Sovereign Wealth and Global Capital at
the Fletcher School of Tufts University
outside Boston. "They should be willing to pay up when
necessary. Some of the multi-factor approaches are more
On the Cusp
In particular, implementing a momentum-based
strategy can require finessing and insight. "Momentum
strategies are not easy unless you have an experienced group,"
says Research Affiliates’ West, "Little moves
drive the price."
One key is disciplined rebalancing. "Market
weighting puts most of the money in overpriced stocks," says
West. "You need to break the link between price and portfolio
weighting through rebalancing."
That’s actually tougher than it may
sound. "Rebalancing is by definition selling your winners and
buying the losers," says West. "It inherently goes against
market sentiment and it’s inherently contrarian.
It requires guts and intestinal fortitude."
The goal of smart beta is often less about
beating benchmarks than lowering volatility. One organization
focused on honing its smart beta strategies internally is
AIMCo, whose MacMaster says the team has had several years
striving and often succeeding in besting benchmarks. "We also
do minimum variance, which allows you to create a portfolio
that has less risk than the market beta — but with
higher return, which is counter to what financial theory would
say, but nevertheless that’s been a product
that’s worked," he says. "We continue to develop
new models and backtest research to stay on the cusp of
Sovereign wealth funds, as is the case with many
investment strategies, need to commit to smart beta for the
long-term. Different factors fall in an out of favor regularly,
like growth and value, and will underperform the general market
when they do so. "Long term they’ve been shown to
add to risk-adjusted returns," says Brett Hammond, managing
director and head of multi-asset research at MSCI. "But
that doesn’t happen all the time."
The so-called quality factor, which typically
measures earnings and return on equity, for example,
didn’t generate excess returns from
2002-’06, Hammond says. "If you had been a
manager, you would have been fired if you followed that
factor," he adds.
Likewise, in its 2013 study, MSCI’s
data shows the small-cap tilt underperforming the MSCI World
Index, 6.5 percent gross annualized versus 6.7 percent for the
10 years from 1992 through 2002. That’s a long
time to trailing. Still, says Bryan, "If you’re
chasing a risk premium, it’s likely that it will
As more money floods into a relatively finite
number of strategies, it seems almost inevitable that some will
lose favor as assets pour in. "If these effects are created by
behavioral biases, the profit opportunity will likely
dissipate," says Bryan. "You look at it on a case by case
basis. Why does it work? Who’s on the other side
of the trade?"
Then there’s the big industry
question. Who wins and who loses with the rapid adoption of
smart beta strategies? The answer isn’t all that
clear. Active managers and hedge funds might be pressured to
lower their fees, or pivot to strategies that
can’t easily be replicated via smart beta, such as
macro, geographic, or sector rotation. Indexers may be forced
to roll out more finely tuned and esoteric passive indexes. In
any case, everyone will be forced to adapt.