The Triumph of the Quants
With advances in technology, these days everyone can become a quant. So-called “smart beta” indices promise cheap, easy and transparent access to rules-based investment strategies across asset classes. In turn, equity market factors such as value, size, quality, low volatility and momentum are now available to retail investors via the exchange-traded fund (ETF) market.
But does the smart beta boom make sense or is it another marketing gimmick? And what’s the best way to implement a smart beta strategy? During a two-day September conference organised in Munich by STOXX and the German CFA Society, “Smart Beta—the 360o overview”, participants discussed these questions in depth.
From theory to practice
“There’s nothing new about smart beta”, said Andreas Sauer, CEO of global macro specialist Ansa Capital Management. “Ever since the introduction of the Capital Asset Pricing Model (CAPM) in the 1960s, researchers and market practitioners have argued that there are other forms of systematic risk in the equity market than just a single market factor, called beta.”
“Smart-beta strategies aim to exploit anomalies that have been known about for years,” said Sauer. “Academics wrote about the low-volatility and value effects in the 1970s, the size risk premium in the 1980s and momentum in the 1990s. What we call active quantitative equity investing has always been about smart beta.”
“It’s easy to see why using the capitalisation-weighted index as the basis for an investment strategy seems flawed,” said Sauer. “Why would anyone want to invest more in a company just because its market size is greater?”
“Slowly but surely, many investors are rethinking traditional approaches to portfolio asset allocation”, said Sara Shores, global head of smart beta at BlackRock.
“Smart beta is redefining passive investing by expanding the range of outcomes available to investors,” said Shores. “You should be as diversified as possible across the things that actually drive returns. In our view, that’s factors.”
Andrew Lapthorne, quantitative strategist at Société Générale, argued that a factor-based approach to equity investing helps investors focus on the ultimate drivers of the share market’s returns.
“Cutting the equity market up into factors is very useful,” said Lapthorne. “It then starts to look more like the fixed income market, which is divided into different risk-return segments such as government bonds, high-grade corporates and junk bonds.”
The role of cap-weighting
According to Yves Choueifaty, president and Chief Investment Officer of TOBAM, the asset management industry has become hampered by the widespread use of capitalisation-weighted indices.
“The real dilemma for investors is not between being passive and active: it’s whether you want your portfolio to be biased or diversified,” argued Choueifaty.
“There is no smart beta but there is dumb beta in the form of the market cap-weighted index,” said Choueifaty. “The cap-weighted index is an output of our industry. We shouldn’t use it as an input. The widespread use in asset management contracts of tracking error targets against the cap-weighted benchmark has also had a pernicious effect”, said Choueifaty.
“Tracking error is not a measure of risk—it’s a measure of the distance between two portfolios,” he said. “As soon as you run your portfolio with a tracking error metric, you are doomed to underperform as you will be forced to cut your bets at the worst time and to implement the bets you didn’t want, also at the worst time.”
“However strong the theoretical arguments against cap-weighting, those considering smart beta as an alternative should proceed with caution”, said Ansa Capital’s Andreas Sauer.
“Moving away from cap-weighting makes a lot of sense,” said Sauer. “But investors should never buy smart beta because of its historical outperformance. Beating the market is not as easy as it may look on paper and the average investor is not dumb. And while we all argue that cap-weighted indices are inefficient, very few investors manage to beat them consistently.”
Towards greater active risk
A likely outcome of increasing investor demand for smart-beta strategies is a rethink of the role of the active manager.
“Smart beta is increasingly available at lower cost, so investors need pure alpha from their active managers,” said BlackRock’s Sara Shores.
An asset manager agreed with the argument that his role may need redefining.
“There’s been a structural change in the market over the last few years, with the rise of systematic, mechanistic investment approaches,” said Thomas Meier, head of equities at MainFirst Asset Management.
“Our industry has become too risk-averse. Active managers have to act, not just react,” argued Meier, who told the conference attendees that he recently asked a potential client to do away with a portfolio benchmark altogether to allow MainFirst to take more concentrated active positions.
Diminishing returns? The implementation challenge
Could smart beta eventually become a victim of its own success?
Some arguments for the persistence of smart-beta returns seem solidly founded in theory. Small-cap stocks may have outperformed large ones because they are riskier and less well researched. Value stocks may have done better than more expensive stocks to compensate for a higher risk of bankruptcy.
But as the volumes of money flowing into smart beta increase, a crowding effect might start to impact performance, argued Société Générale’s Andrew Lapthorne.
“The excess return on many smart beta strategies starts to decline as the capacity of the strategy increases,” said Lapthorne.
“Rebalancing also becomes potentially more costly as the volume of money tracking indices increases,” added Lapthorne. “There are scores of traders out there seeking to second-guess the price moves of stocks entering and exiting indices.”
But there are ways for the managers of index-tracking funds to disguise their trading intentions, argued BlackRock’s Sara Shores.
“The worst thing a passive manager can do is to put on the whole rebalancing trade at the close of the market on the date index changes become effective,” said Shores. “That’s a way of destroying wealth for your clients. We want to be mindful of the cost and impact of any trade. At the same time any time I deviate from rebalancing on the effective date I’m taking risk, which has to be justified.”
Putting a smart-beta strategy into practice was the focus of a second day seminar, run by Angelika Bolliger, head of market development at STOXX and Todd Mathias, vice president at BlackRock.
Bolliger and Mathias told the conference attendees how they had designed an index for a client wishing to replace an active manager of European equities.
The index had to follow a similar investment concept, be transparent and easily replicable. The strategy was to achieve a yield 1.5 times that of the European equity market, with both value and quality tilts and a maximum 8% error against the cap-weighted index.
The index, designed in partnership by STOXX and BlackRock, used a percentile-based yield filter to select higher-yielding stocks, together with maximum price-to-book and price-to-earnings ratio filters and a minimum return on equity filter to achieve the value and quality tilts, respectively.
But the two firms also had to bear in mind the practicalities of investing, said Bolliger and Mathias.
“The designer of a smart-beta index has to consider potential capacity issues, index turnover and the associated costs, the possibility of having to liquidate the portfolio in a stressed market, the degree of optimisation and the frequency of rebalancing,” said Bolliger and Mathias.
“There are no right or wrong answers to these questions, but you need to focus on them to make a smart-beta strategy fit for purpose,” they said.
The role of ETFs
Increasingly, investors can select from smart-beta strategies via the ETF market, explained Erol Steiner, co-founder of Munich-based trading firm Crossflow Financial Advisors.
Steiner noted the importance of transaction cost analysis when selecting any ETF and, particularly, those in the smart-beta segment.
“While there’s an old saying that an ETF is as liquid as its underlying index,” said Steiner, “it’s also worth remembering that ETF bid-offer spreads vary according to a fund’s size, its daily turnover, the number of designated sponsors and the number of cross-listings.”
Steiner showed examples of historical median bid-offer spreads from Germany’s XETRA exchange for two minimum volatility ETFs, comparing them with the lower spread on an ETF tracking a cap-weighted index.
“Remember that a market-cap weighted index has its largest weightings in the largest stocks, which are usually the most liquid,” said Steiner. “As soon as you start to move away from cap-weighting towards smart beta, your trading costs are going to increase.”
Smart beta goes global
On the second day of the conference, Johanna Treeck, senior ECB correspondent at Market News International, spoke of the challenges that still lie ahead for policymakers in the eurozone and further afield.
Treeck reminded attendees of ECB president Draghi’s recent comment that "in a monetary union you can't afford to have large and increasing structural divergences between countries. They tend to become explosive."
Whatever the regional challenges, the signs are that smart beta is going global. In 2014 Japan’s $1.3 trillion Government Pension Investment Fund decided to allocate money to a new index-based strategy, focused on companies with a high return on equity (RoE) and superior governance policies
Satoshi Sakamaki, head of the investment planning group at Mitsubishi UFJ Financial Group, described his company’s collaboration with STOXX in the creation of a new quality equity index, the iSTOXX MUTB Japan Quality 150. Sakamaki spoke of his optimism for the development of smart beta in Japan.
“Assets under management in smart-beta strategies in Japan are increasing rapidly,” said Sakamaki. “We expect an expansion of the investor base and of the low-cost passive funds market in the form of ETFs.”
The STOXX/CFA conference finished with a discussion of equity dividends and the roles of active and passive managers in a dividend-focused strategy.
“Dividend indices are flawed”, said MainFirst’s Thomas Meier, “since they are backward-looking and don’t warn you when a constituent company may cut its payout”.
“Everyone uses consensus fundamental data. The index may react to changes in company fundamentals but only after the stocks have performed very badly,” said Meier.
Index designers can add enhancements to dividend indices to try and improve the sustainability of the income stream received by investors, STOXX’s global head of business development, Konrad Sippel, pointed out.
But even if smart-beta indices have occasional drawbacks, they still fulfil an important need for investors, argued Sippel.
“Study after study shows that active managers fail to match their benchmarks over time. There will always be a role for the truly talented stock picker, but indices are simple and transparent recipes that anyone can follow,” he said.
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The Triumph of the Quants
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