Beta, smart beta, alternative beta: Extracting equity market risk
Some practitioners who criticise the smart beta concept suggest other ways to extract equity market risk, Lynn Strongin Dodds writes
Over the past couple of years, there has been a host of alternative index products coming onto the market. They come with different labels – smart beta and factor investing are two of the most popular – but they all offer the promise of enhanced performance over the market cap equivalent. However, some firms like Boston-based money management firm GMO argue that when smart beta strategies are adjusted for their exposure to small-cap and value stocks, they do not show any significant outperformance of cap-weighted benchmarks over the long haul.
“We do not like the term smart beta because everything gets thrown under this umbrella if it has historically shown a good Sharpe ratio versus the traditional index,” says Ben Inker, co-head of the asset-allocation team at GMO. “We do believe there are different ways to get paid for beta. But investors spend far too much time looking for a free lunch, when they should be looking for the investing equivalent of an inexpensive food-truck meal instead.”
He advocates an approach that dynamically moves between owning stocks, selling equity puts and implementing merger arbitrage trades – embedded in GMO’s ‘Benchmark Free Allocation Strategy’ – suggesting it could be a better formula than smart beta.
“There is nothing magical about our processes but we look at interesting ways where investors can get compensated for a handful of risks,” says Inker.
One of the reasons why investors get paid for selling equity put options is that they are taking equity downside risk. While it would be odd if this always gave a better return per unit of risk than owning the market directly, the different return pattern means that some of the time it almost certainly will.
“The right time could be when valuations are higher than normal,” says Inker. “By contrast, when markets are at their low point, it is better to own the stock directly.”
As for merger arbitrage, the bet is on the stock price of an acquired company rising by a few percentage points while the price of the buyer dips, in between the announcement of a takeover and its completion. Activity withered after the financial crisis but it has received a new lease of life over the past year as the economy, especially in the US, has recovered.
“Merger arbitrage is most attractive when there are a lot of deals and they have some hair on them,” says Inker. “It typically happens late in the equity cycle and occurs when times are good. Investors are willing to take a risk because management feels confident about the future. This is probably a time when the expected return to owning stocks has fallen, and may well also be when investor confidence is reducing the expected return to selling puts directly. There is still equity downside risk but if the deal holds together investors can get cash plus five for taking the risk.”
“We look at interesting ways where investors can get compensated for a handful of risks”
Dhvani Gupta from Barclays’ EFS Solutions team also sees the benefit of using short option positions or variance swaps in a systematic way to capture short-term volatility premia.
“We also use merger arbitrage as a source of risk premia but use a more diversified approach by investing in all deals which satisfy certain size and liquidity criteria,” she says. “One of the problems with short-volatility or merger arbitrage is that, even though they may provide some diversification to an equity market portfolio, the correlation to equities may increase in extreme down market movement. ”
This is a valid point in itself – but of course Inker’s argument is not for an investment strategy that diversifies against equity risk, but rather one that takes equity risk in the most efficient way at different points through the cycle, by combining three methods of taking that risk and tactically allocating between them. It is this that makes it a potential alternative to today’s smart beta solutions.
Altaf Kassam, head of equity applied research at MSCI, agrees with GMO’s premise. “It makes sense, but the factors they describe are more like trading strategies,” he says. “Our clients, though, are looking holistically at their portfolios and trying to see if they can replicate the returns of active managers in more efficient ways. Factor-based investing which looks at risk and return drivers like momentum, value and volatility can smooth out the cyclicality when these are combined. If investors want to increase their chances of consistently outperforming, one approach could be to combine the best active managers with factor-based investing.”
Other industry experts caution further about the commodisation of certain strategies such as merger arbitrage and volatility trading.
“One of the benefits of smart beta is that it enables strategies such as merger arbitrage to be accessed at a lower cost instead of being wrapped up in a more expensive hedge fund vehicle,” says James Price, senior investment consultant at Towers Watson. “The question I would ask is, do active managers have more insight – for example, in choosing the right M&A deals?“
Paul Goldwhite, director, investments and portfolio manager at First Quadrant adds: “A lesson learned from the financial crisis is that you need a wide selection of factors, not only to generate better risk-adjusted returns, but also to protect the portfolio from commodisation – which can happen to certain strategies over time.”
In many ways, it could be argued that the logical end-point of these kinds of debates would look something like the well-documented equity portfolio that Danish pension fund PKA has put together over the past few years. Alongside standard market capitalisation-weighted index positions in developed, emerging, frontier and small-cap equities, the fund implements what most would recognise as ‘smart beta’ approaches – low-volatility portfolios and strategies to exploit value, momentum, quality and other factors. But a third arm of its overall strategy aims to exploit equity-market risks through simplified, systematically-implemented alternative strategies that do, indeed, include volatility and merger arbitrage.
The choice facing investors is largely one about governance capacity: do you only have governance budget for traditional passive; or can you expand into smart beta, alternative beta and active management. Ideally, a strategy should have room for all four.
“It depends on a pension fund’s objectives and constraints,” as Price puts it. “In some cases, funds are prepared to give up the upside in order to reduce volatility and minimise drawdown. In that case, they will use diversifying smart beta strategies but if they want to outperform, they may go to active. Both offer diversification benefits but you have to be careful about making the calls as to which strategies will do better or worse and recognise that how they relate to each other will change over time.”