Clients of Towers Watson, who include pension schemes, sovereign wealth funds and insurers, allocated $5bn (€3.7bn) to smart beta in 2012, taking their total combined assets in such strategies to some $20bn. And demand from large investors shows little sign of slowing.
According to the annual global Bfinance Pension Fund Asset Allocation Survey, published in November, 43% of respondents were considering moving market cap-weighted passive investments to “smart indices and alternative solutions” in the year ahead.
But while institutional investors blazed the trail in smart beta during the past decade – notably those managing pension schemes in the Netherlands, such as APG and PGGM (see box below) – the approach is yet to be embraced by investors with smaller portfolios, despite improved access to such strategies via a burgeoning array of products, including ETFs. So, could smart beta be suited to a wider investor audience than it currently receives? And what are the benefits and pitfalls of employing the approach?
It is important for investors to be aware that, by investing in alternatively weighted indices, they are diverging from the market and the performance could be significantly different, depending on the business cycle.
senior ETF analyst, Morningstar Europe
What’s so smart about it?
Before seeking answers to these questions, it is first necessary to define what constitutes a smart beta index – a task that is either relatively straightforward or rather difficult, depending on who provides the explanation. For François Millet, a managing director at Lyxor, and the firm’s product line manager for ETFs and indexing; and Hortense Bioy, a senior ETF analyst with Morningstar Europe, the approach can be summed up in a sentence or two.
“Smart beta is anything which is non-market-cap-weighted, in the area of either equity or bond indexing, and which aims at capturing a systematic risk premium – something which cannot be diversified away, like the value premium or the volatility premium,” says Millet.
Bioy offers an even more succinct response: “We call them alternatively-weighted indices. ‘Smart beta’ is a marketing term but they are just alternative beta strategies.”
Yet for others, the picture is more complex. Deborah Fuhr, a co-founding partner at ETFGI and former global head of ETF research at BlackRock, argues that a simple “alternatively-weighted” definition is too broad, given that it would encompass long-established price-weighted benchmarks including the Dow Jones Industrial Average and Nikkei 225. Fuhr recently took part in a smart beta discussion with representatives from Towers Watson and State Street, among others. The panel failed to arrive at a universally-accepted definition.
“If at that level there is no agreement, you can imagine how [difficult] it is on the financial adviser and retail side,” she says. “So there is a huge challenge. What is it? What does it mean? When do I use it? How does it compare with things I know and understand, and which are quoted in newspapers – like the S&P 500, the Cac and the Dax? There is no agreement as to what smart beta is, or what it is not.”
Even the term itself is problematic, Fuhr adds, because “it implies that what [index investors] have been doing is dumb”.
While a standard definition remains elusive, it is possible to identify trends in this area. Looking at the European ETF sector, for example – which Bioy estimates offers about 60 alternative beta products with combined assets of more than €5bn – there has been a clear shift from fundamental to risk-budgeting strategies.
Products launched between 2005 and 2009 tend to focus on fundamental factors, with firms weighted according to their dividend history, book value or cash flows. Some of the largest non-traditional ETFs take this approach – including the €300m iShares DivDax Fund, unveiled in 2005 and which provides exposure to the 15 highest-yielding German companies in the 30-stock Dax Index.
Risk-weighted strategies have come to the fore during the past five years. Lyxor, which manages more than €1bn in smart beta solutions and ETFs, began running risk-weighted mandates in 2010 and launched its SmartIX Equal Risk Contribution (ERC) equity indices in 2011 – in eurozone, Europe, US, Asia Pacific and global variants.
Calculated independently by FTSE, these indices aim to equalise the risk contribution of large cap stocks in each of their underlying benchmarks, while weighting mid and small cap components by market cap. According to Lyxor, historical simulations show the indices outperform their traditional counterparts over a market cycle, with less volatility and greater diversification.
In line with the findings of the Bfinance survey, Millet says such risk-weighted strategies are increasingly being adopted by “top-tier” investors seeking to mitigate risks associated with their traditional index exposure, such as momentum bias and concentration. Accordingly, Lyxor prices its smart beta solutions only marginally higher than the market cap-weighted equivalent.
“We want these allocations to be held alongside traditional indexations in the portfolios of institutions, for buy-and-hold positions,” Millet adds. “So smart beta is not that much more expensive than the traditional market cap-weighted approach.”
Another growth area is minimum volatility, which offers the enticing prospect of lower risk than a market cap-weighted index, as well as superior returns. The strategy has proved popular in the US – a story illustrated by the Invesco PowerShares S&P 500 Low Volatility Portfolio (SPLV). Since its launch in May 2011, the fund, which holds the 100 lowest-volatility stocks from the S&P 500 over 12 months, has amassed assets of more than $3bn. Millet notes that the ETF market is more retail-orientated in the US than in Europe, and says SPLV is an example of appetite for smart beta among smaller investors.
Indeed, Millet is enthused by the outlook for adoption of the smart beta approach by new investor groups over the next two-to-three years, and says the firm’s alternatively weighted offering is attracting greater attention from European private banks. However, Bioy and Fuhr sound a note of caution on the arrival of non-institutional investors to the smart beta space. Both say it is important for investors to be aware that, while such strategies have potentially beneficial attributes, they may also carry unanticipated risks.
“Investors in passives are increasingly interested in [smart beta] strategies because of the flaws they see in market cap-weighted indices,” says Bioy. “But these alternative strategies create tilts and biases – mainly to value and small caps. So it is important for investors to be aware that, by investing in alternatively weighted indices, they are diverging from the market and the performance they will get could be significantly different, depending on the business cycle.
“For example, an equal-weight index will outperform the market in cycles where small caps are in favour, because the smallest caps have bigger weights than in a market-cap-weighted index. But in market downturns, this strategy will likely underperform.”
This theme was developed by Robeco’s head of quantitative equity research, David Blitz, in a white paper published last December (see table above). He found that the most popular smart beta strategies often have tilts which involve “undesirable” risks.
Fuhr agrees that smaller investors should exercise caution. “It is like baking a cake,” she adds. “If something is low-fat, it means you are taking something out of the standard recipe, or using a different ingredient. So people have to understand that it may taste different, or act differently.”
Dutch pension funds – leading the way
Netherlands-based retirement schemes were early adopters of smart beta, and continue to invest significant portions of their portfolios in the approach. APG, which manages some €320bn in Dutch pension assets, is one of the biggest exponents of smart beta strategies. The group ran €44bn of its €85bn developed markets equity portfolio in smart beta at the end of January. “The quant equity team is running one of the largest minimum volatility portfolios in the world,” says Gerben de Zwart, head of quantitative equities research at APG.
“Since its inception, this [€7bn] actively-managed smart beta strategy has performed well, both against its smart beta benchmark and the market. APG is convinced that this smart beta should be part of the equity portfolio of each pension fund, because the strategy could achieve the same long-term returns as a classic equity strategy with 25% less risk.” APG also runs a ‘focus equity’ strategy which owns large stakes in companies and is designed to deliver a risk-return profile that fits the needs of pension funds, de Zwart adds.
Similarly PGGM, which runs €130bn in pension assets and supports five Dutch pension funds, holds 40% of its equity portfolio in value, minimum variance and quality ‘alternative beta’ strategies. “The implementation [of smart beta] started in 2005 and took until 2009,” explains senior PGGM strategist Mark Voermans. “These alternative betas reduce the risk of our portfolio significantly, and we expect at least a comparable return over a business cycle.” He says smart beta is well-suited to the long investment horizons of pension funds and PGGM is happy with the results so far.