Smart Beta: Promise and Pitfalls for Sovereign Wealth Funds

April 08, 2015 by Loch Adamson

Sovereign Wealth Funds See Risks and Opportunities in Smart Beta
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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 popular strategy.

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 important. 

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 sense.

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 billion Petroleum Fund of Timor-Leste is considering allocating 5 percent of its assets to smart-beta strategies.

Combining Factors

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.

Wiped Out

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 Morningstar . "You know what you’re getting.They follow the rules."

Such transparency means that state-owned investors can learn about strategies by simply reading the prospectus. That in itself can shield them from unintended consequences.

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 manager."

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 nuanced."

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 that." 

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." 

Chasing Premiums

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 continue."

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.

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