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Over the past 10 years there has been a revolution in the asset management industry. The ability of stocks with certain investment characteristics, such as value and momentum, to outperform the market has been well understood and documented for decades. But options of how to implement this strategy were limited.
For many years investors had no choice but to choose an active manager who selected those stocks with a particular characteristic. The development of the exchange-traded fund wrapper and the ability of asset managers and index providers to handle higher quantities of data changed all that.
Now it’s possible for institutional investors to choose an ETF that will systematically select stocks with characteristics like low volatility and growth at lower cost.
Investment fundamentals remain unchanged
Adding new tools to the kit available to institutional investors does not, however, change the fundamentals of investing. When a pension scheme or an insurance company sets their strategy, they carefully assess the risk-return profile they require to meet their liabilities.
Once these high-level goals have been set, trustees and asset allocators can turn their attention to which asset strategies will enable them to meet their goals. The development of smart beta gave many institutional investors access to a particularly useful tool – ‘low volatility’ equity funds.
In the aftermath of the global financial crisis, institutional investors were concerned about the inherent volatility of equity markets. The introduction of ultra-low monetary policy exacerbated those concerns – their liabilities ballooned as bond rates tumbled.
These institutional investors faced a tough conundrum: their funding gaps had risen, which required a more aggressive investment strategy to generate the returns to narrow. But at the same time these investors were wary of over-allocating to risky assets like equities. Their high volatility makes steep market corrections highly likely, which they could ill afford.
Low volatility proved popular with institutional investors
Low volatility equities provided the perfect solution to many European pension schemes. They could still access equity markets but with less risk than conventional strategies. And this could be done through low-cost vehicles, such as ETFs.
Investors were pleased. These allocations performed well in the aftermath of the financial crisis because the market conditions favoured this investment characteristic.
This strategy works well during periods of economic contraction, which can often translate into market corrections and increases in volatility. But it will usually underperform in a bull market which could be accompanied by increases in interest rates.
Using a low volatility strategy allowed institutional investors to become familiar with smart beta strategies. They became more comfortable with this investment concept and, as economic growth recovered and equity markets started to perform well, they realised there was a broader universe available.
Growing awareness of the difference in Performance
The inverse correlation between the economic recovery and low volatility stocks also made investors aware of the performance behaviour of a particular investment factor.
Stock characteristics can be divided into two broad groups: those which have defensive characteristics and those which have cyclical attributes. Like low volatility, the ‘dividend’ and ‘quality’ factors tend to perform well when the economy is contracting. They are defensive attributes.
The ‘dividend’ factor selects those stocks which can deliver a sustainable high income. This characteristic has been popular as investors sought alternative sources of yield in a low interest rate environment.
The ‘quality’ factor emphasises those companies with lower debt and higher profit margins than the market average. Most importantly, these firms are capable of comfortably generating regular cash flows. These corporates provide a measure of protection during a period of rising interest rates because of they have few liabilities on their balance sheet.
When economies start to recover and financial markets rise, these defensive factors will tend to underperform the broader market and it is those with cyclical characteristics that will perform better.
For example, the ‘value’ factor will perform well when investors are more inclined to take risks. This usually happens during periods of economic expansion when inflation and interest rates increase. The share price of these stocks tends to rise in these conditions.
The ‘size’ attribute – which selects smaller and mid-cap stocks – is another that performs well during times of economic expansion. These companies need a positive environment to perform well and struggle when growth is stagnant.
‘Momentum’ also does well during periods of economic expansion, particularly in the later stages of a financial bull market. This strategy selects those stocks which have performed strongly recently as they are likely to continue to outperform the broader market.
When one is not enough
Investors faced a choice as they became more familiar with the universe of investment factors and their relationship to each other, the economic cycle and financial market trends. In order to maximise the performance of their allocation to these strategies, they realised focusing on only one or two would not achieve this goal.
As their knowledge increased, their implementation of these strategies became more sophisticated. They started to allocate to multiple strategies to get the best results over their long-term investment horizons.
Aware of the relationship between a particular factor and the economic outlook, investors could chose to time their asset allocation decision. For example, they could switch to value, size and momentum in times of expansion and to low volatility, dividend and quality during periods of contraction.
But institutional investors know how difficult it is to make accurate market timing decisions. This introduces a significant new risk into their investment implementation which, after all, is targeting a specific risk-return profile so they can meet their liabilities.
And those market timing decisions are made all the more complex by the current economic environment. Even though many regions are heading towards a period of more normalised monetary policy, the impacts of a long period of very low interest rates lingers.
The evolving relationship between factors and economic as well as market conditions makes timing market decisions look even more unappealing. The more rational conclusion is to combine different factors into one portfolio.
By mixing different investment strategies, institutions can add diversification to their portfolio due to the complementary behaviour of the factors during different economic and market phases.
How to allocate to different strategies
Once investors have decided to use several investment factors, then they need to decide how to allocate the portfolio among them. As providers have become more sophisticated, the options available to investors have increased.
Investors could simply decide to allocate equal proportions of their portfolio to each strategy. But as many institutions are focused on the risk-return profile of their assets, allocating according to the relative risk of each factor might be a more appealing idea.
For example, the Multi-Beta Multi-Strategy ERC index created by ERI Scientific Beta in partnership with Amundi, does exactly that. It combines four factors – value, momentum, low volatility and size – according to the relative risk weightings of these indices.
Growing concern over equity market volatility
Institutions are becoming increasingly wary of equities. Even though an allocation to multiple factors will help to diversify the risk, it cannot negate the exposure to the direction and volatility of those markets.
The performance of equities has been exceptional. The Stoxx European 600 index has risen by 173% since March 2009 and is now close to an all-time high. The higher a financial market climbs, the greater the likelihood of a correction.
Not only does a fall in markets become more likely as prices beat historic peaks, but the pain also increases. Investors can ill-afford to relive the loss of capital values they experienced during the financial crisis. This desire to reduce risk increases the appeal of market neutral strategies.
One way to continue to exploit equity trends while being insulated from any potential market corrections is to use a long-short strategy. Traditionally these funds produce returns through stock selection while a hedge minimises the exposure to any market corrections.
It is possible to develop a similar strategy for investment factors. For example, by taking a long position in equity factors to harvest risk premia and hedging this exposure by selling equity futures on a liquid, broad European stock index.
This is the strategy used by the iStoxx Europe Multi-Factor Market Neutral index. It embeds six factors: value, size, quality, carry, momentum and low risk.
Each constituent stock of the Stoxx Europe 600 index has a multi-factor score calculated by average of each individual risk factor. Then 50 to 120 stocks are selected for the index through an optimisation process. This long position is counterbalanced with a short position in Stoxx Europe 600 futures roll index.
The combination of this long exposure along with short futures hedge removes the equity market beta, allowing the ETF to provide exposure only to the targeted investment factors.
Historical data shows this strategy will produce a potential performance outcome where the net result is somewhere between the returns on equities and fixed income but with bond-like levels of volatility.
The advantage of a market neutral ETF is that it is a cost-effective off-the-shelf solution for institutional investors. But many pension schemes and insurance companies prefer a bespoke investment strategy which meets their particular risk-return requirements.
Smart beta strategies become ever more sophisticated
Using investment factors in market neutral strategy is only one way the use of smart beta is becoming more sophisticated. For example, there is growing recognition that factors can be implemented in multi asset and fixed income for instance.
Of all those asset classes, bonds are perhaps one of the most interesting because it is such a fundamental part of any institutional investor’s portfolio.
But using fixed income investment factors has specific liquidity features and is more fragmented than other asset classes. Academics and companies such as Amundi are currently researching how bond investment factors can be exploited.
Fannie Wurtz is managing director, Amundi ETF, Indexing & Smart Beta
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