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Getting Smarter About Advanced Beta
Whether it’s called advanced beta or smart beta, there are now many innovative ways to measure market performance and help deliver less volatile returns. Joining moderator Evan Cooper to discuss these new alternative beta strategies and techniques are:
- Dodd Kittsley, Global Head of ETP Research, BlackRock
- William Belden, Managing Director, Product Development, Guggenheim Investments
- Anthony B. Davidow, Speaker Job Title Vice President, Alternative Beta and Asset Allocation Strategist, Schwab Center for Financial Research®
- Luciano Siracusano, Executive Vice President-Head of Sales and Chief Investment Strategist, WisdomTree Asset Management, Inc.
Bookmarks:
0|ETF Masterclass
326|Advanced beta
629|Using advanced beta for clients?
889|Aware of performance
1229|Low volatility strategies
1551|A view on the future
1988|Allocation
2342|Popular amongst institutions
2723|Advanced beta and fixed income space
2844|Final thoughts
Duration:
00:52:02
Recorded Date:
9 October 2013
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Transcript:
Evan Cooper: Welcome, I’m Evan Cooper of Investment News and in today’s Masterclass we’ll be discussing advanced beta. With me today in New York are our expert panellists, William Belden, Managing Director of Product Development at Guggenheim Investments, Tony Davidow, Vice-President and the Alternative Beta and Asset Allocation Strategist at Charles Schwab, and Luciano Siracusano, Chief Investment Officer of WisdomTree, and joining us in San Francisco is Dodd Kittsley, Head of ETP Research at BlackRock. Welcome gentlemen.
So, what exactly is advanced beta or as it’s often called smart beta or alternative beta? As we’ll find out there are many schools of thought as to what advanced or smart beta actually is. Regular plain old beta of course is a measure of stock market volatility. Traditionally market capitalisation based indexes had been used to measure the market, but over the years critics have said that cap weighting gives too much emphasis to overvalued stocks and too little to undervalued stocks, which can distort the picture of true market performance and lead to suboptimal returns. Enter advanced or smart beta which attempts to deliver a more accurate picture by using indexes weighted by alternative factors such as volatility, dividends, book value or sales. So, while advanced beta is index investing, it’s definitely not plain vanilla index investing and with so many smart or advanced beta flavours it can be a challenge to pick the right one then use them correctly. So, Bill, let’s kick it off with you; tell us how alternative beta and alternative indexing can help advisers help investors.
William Belden: Good to be with you Evan, thank you. I think some of your definitional work helps support the discussion around what actually is defined as beta alternative or smart beta, so really providing that exposure to the market is what we’re trying to achieve and what is the best way to provide that type of exposure, regardless of what segment of the market of the overall market. And in doing so you’re trying to achieve investment results, everyone has an investment objective that they’re seeking to achieve, and the smart beta strategies have been developed I think to improve upon what the choices are that investors have had available to them to achieve that type of exposure in pursuit of pursuing their investment objectives.
Evan Cooper: So Tony, let’s hear from you, tell us a little bit about smart beta or advanced beta and what it means.
Tony Davidow: We actually like the term smart beta or alternative beta and I do think they are an evolutionary step forward, and if you think of the genesis of the growth of the ETF business, the first foray was to provide cheap beta, exposure to virtually every market segment in the most cost efficient manner. Nothing wrong with that, but I think as the academics and the institutions began to really probe into, are there better ways of owning market segments, the innovation of these alternative beta strategies began to come to the forefront, and we think they’re terrific because they’re an evolutionary step forward. What we would argue is market cap and many of these alternative beta strategies complement one another because what you do is you address some of the tilts and biases that exist in one or more of these strategies. So, we think they’re evolutionary, we think they’re definitely moving the ball forward down the road, but we’re not completely departing away from market cap strategies, they certainly have a role, and there are certainly market environments they perform better than these strategies.
Evan Cooper: And Dodd, you’re an advanced beta aficionado, tell us your view of advanced beta and what it means.
Dodd Kittsley: So much has to do with the proper definition and I agree with Bill and Tony, they bring up some very good points. It is an evolution, not just in the indexing industry but also with investment products such as exchange traded products as well, and we’ve seen this evolutionary growth and I think it is a good complement to market cap weighted type of strategies, but it’s the next generation in exchange traded products, non-market cap weighted ETFs, and I think that’s the easiest way to pin a kind of blanket on what we’re talking about here. There’s certainly very specific iterations of that, but non-market cap weighted exchange traded products today represent 16% of total equity ETP assets, yet we’re seeing a significant demand in growth where 32% of the flows, 32% of the net new dollars invested in exchange traded products year to date have been in these type of strategies. I know we’re going to get into some of the specifics about what we mean here, but in our definition at BlackRock, again it’s anything non-market cap weighted which can include things like dividend weighted, fundamental weighted, packaged baskets, factors, enhanced indexing. There’s a lot of exciting strategies where there’s been tremendous demand for the last decade and we’ve only recently seen a significant uptake in investable products that make these types of objectives investable.
Evan Cooper: And Luciano, give us your wisdom from WisdomTree on advanced beta.
Luciano Siracusano: Well you could call it advanced beta or smart beta or clever beta or better beta, all I know is we’ve been focusing on this for about ten years and we started with the premise that the cap weighted indexes were non-optimal, and when we say non-optimal we’re talking from an investor’s perspective and the question was; was there a way to get higher returns and lower volatility by owning the market, but not owning the market, market cap weighted, and that was really our approach. So we try to incorporate in our view the best practices of indexing which is to get very broad exposure to equity markets. We have representative exposure to the asset class. We have investable securities and where you’re minimising stock selection risk by owning in effect all the stocks in that market, just like a cap weighted index would, but unlike a cap weighted index you’d have a mechanism once a year to rebalance the portfolio back to some measure of relative value. And we tested all the measures of fundamental factors and we decided if you pick dividends, that’s a function or a factor you could apply around the world, so our view of a fundamentally weighted is to try to own the market but have a mechanism once a year that allows you to reweight the market back to some measure of income.
Evan Cooper: So, looking at it from an investor’s point of view and obviously the proxy would be the advisers, you take a market cap weighted index and then you take the alternative, a smart or some other alternative way of looking at the index; how much better are the returns or are they better from the alternative way of looking at things than from the traditional way of doing the indexing, and does better always apply to the smart or to the advanced approach?
Tony Davidow: It doesn’t always apply but I think there’s a lot of academic research, Rob Arnott and Russell and WisdomTree and work that we’ve done at the Schwab Centre for Financial Research suggests that you do get a pretty significant outperformance coming from these alternative beta strategies. That’s the appeal. I think that’s exactly the point that Luciano was making, better risk adjusted results come from the reweighting, moving away from the non-cap portfolio, but I think to your point they don’t always perform better. Think of a time period like 2012 where Apple’s the darling of Wall Street and Apple’s up 65% in the first three quarters of the year. It was very difficult for a non-cap weighting portfolio, a portfolio that’s going to underweight Apple to outperform. So, over longer intervals we see outperformance but over shorter intervals there would be periods of time, think of boom and bust periods, boom periods like the tech bubble or the financial crisis, or think of periods of time where you’re awarded, where the biggest companies were the best companies and performing the best, those are impediments for these alternative weighted strategies. But over longer intervals I think all the research suggests there is excess return generated from non-cap weighted strategies.
William Belden: I would just add to that, Luciano pointed out you are seeking an optimal risk/return profile here and Tony added to that by saying that everyone has a time horizon that they’re looking over, so different time horizons produce different results and frankly they will favour some fundamental or some smart beta strategies over other smart beta strategies in comparison to the market cap weighted strategies. So I think you have to set forth what the investment objective is, identify that, in conjunction with that identify the time horizon that you’re seeking to pursue that investment objective and then I think you can make an evaluation for some of these smart beta indexes, and how they can help you achieve that objective a little more efficiently than perhaps what some of the traditional market cap weighted indexes can position you for.
Evan Cooper: Okay and Dodd, can you, if I may use the term, weigh in on that, in terms of when alternative beta strategies work better than the conventional ones?
Dodd Kittsley: Absolutely yeah. I think the other gentlemen have brought up some great points in terms of time horizon is critical. Certainly over the long term there’s been a lot of work showing there is persistent risk premia in certain factors such as size. In general over the long term small caps outperform large caps. In terms of value, over the long term value stocks outperform growth stocks, but the important thing with alternative beta, differentiated beta, whatever we’re going to call it today, is understanding what you own and understanding what your bets are or your risks and exposures and how they’re different from a market cap weighted index. So, in our view a lot of these factors want to be used by investors over specific time horizons to reflect a view, whether it be value over growth, small over large, dividend payers over non, high quality companies over lower quality companies; those sort of things have been incredibly attractive and now again are investable through exchange traded products.
Evan Cooper: So, I guess the question could be, where now; what would an adviser or should an adviser in your opinion be doing for clients at the current moment, using a mix perhaps of traditionally weighted index products and alternative or advanced beta strategies? Luciano, what do you think, where does it fit now?
Luciano Siracusano: Well, I think the first place to look if you were starting fresh is the less efficient markets, because the less efficient market I think there’s more room for outperformance relative to cap weighted. You heard earlier Dodd made the point about value and growth, very important, because a lot of these fundamentally weighted strategies do have a value tilt to them. What’s interesting in the last five years growth outperformed value in America so you would expect these strategies not to have done so well. What’s interesting when you look at what we’ve seen in the US we have an earnings weighted small cap index which takes all the profitable companies weight by earnings, that index outperformed the Russell 2000 by five percentage points a year annualised, even though growth beat value in that environment, the mid cap outperformed the S&P midcap by 400 basis points even though growth beat value, so I think there’s something to be said about rebalancing back in less efficient markets, and we saw the same thing in emerging markets. I think that’s really the place to start because I think the evidence is saying, there’s something going on here that’s more than just a value bet and I think that that’s the one myth that’s been punctured by the real time data that with fundamentally weighted indexes you’re actually taking advantage of inefficiencies of the markets and possibly even mispricings of the market, and you could have mispricing in the core of the market or in the growth quadrant of the market, it’s not just a value index dressed up in garb.
Tony Davidow: And if I could just add to that because I think you raise something interesting. We’ve been talking for ten minutes and we’ve been teasing around the different terminology, but I think one of the most important things for the advisers and ultimately for the investors to understand is you need to strip back and really understand some of the biases introduced by these strategies. And I would say, we like the term alternative beta or smart beta, whatever you want to call it, but if you think about what fits in that family that’s typically referring to things like fundamental which come in different flavours; low vol strategies, high beta strategies, equal weight strategies. So I think as a starting point the investors really need to understand what is the underlying methodology, how are you constructing the portfolio in the first place, what’s the underlying indices because the indices does matter quite a bit and then as you strip it back and you start to look at it you start to see different characteristics fall out of this.
And we’ve actually just completed some research looking at the alternative beta landscape and I think you find dramatically different results, even dramatically different results if you look across the fundamentally weighted strategies, although they typically have a value tilt, depending on the factors and depending on the methodology you’re going to have different weights and different biases that are introduced. So, as you asked the question about advisers and investors and how they should think about this, the first thing they should understand is what are they owning and how are they owning it, and then I think it’s a much more intelligent discussion to think about how am I using this in conjunction with a market cap portfolio, or maybe I’m using it in conjunction with an active manager, but if you strip it down and really understand the bets you’re making you’re going to have a better outcome in the long term.
William Belden: Yes, I think that we’re talking about portfolio construction a little bit here and keeping in mind that the performance of an investor’s portfolios depend upon all the inner workings of the portfolio construction process, so whether fundamental indexing or smart beta is utilised in conjunction with other smart beta strategies or as a complement to market cap weighted indices, the outcome is going to be the most important result here. And we view investors facing significant headwinds as it relates to making sure that they’re getting compensated for the risk that they’re taking on in their portfolio construction, so with markets being fairly volatile we want to make sure that the investors understand the risk that they’re exposed to and how they can formulate a portfolio to ensure that they’re positioned to realise the return opportunity that aligns with that type of risk exposure, which is I think in many ways the beauty of the exchange traded fund or the passive investing that tracks indexes, because as Tony suggested knowing what you own is critical at all times and ETFs provide that.
Evan Cooper: I’m just curious in the prospectuses of these index funds, do they state this will do well in this kind of market, this will do less well in that kind of market; how would an investor and an adviser even know how, they know the construction but how they will perform under different scenarios, is that clear?
Tony Davidow: I haven’t seen a lot of people saying that my strategy won’t work in this environment, so I think it’s an excellent point, and again the Schwab Centre for Financial Research is an independent think tank and we’re charged with looking at the whole landscape and really trying to help advisers make those better informed decisions.
Evan Cooper: So from Schwab would they buy something, I mean I’m being snarky here but.
Tony Davidow: Well, I think we’re addressing kind of the elephant in the room which is it is a very difficult thing for the average consumer to understand what they own. It’s easy because you can look at the underlying holdings but do they take the time to do that, and you’re right, the marketing materials really aren’t saying it. So what we’re trying to do is we’re trying to unveil a little bit and give people a little bit of a better road map to say they’re all good strategies but they’re not all going to work in every market environment, and if you actually could strip it down a little bit and understand maybe some of the bets and biases that are introduced, are you benefiting more from a smaller mid cap effect, are you more of a value tilted portfolio, it allows you to make better informed decisions going forward.
Evan Cooper: But to that point, we’ll get to Luciano too, how does an investor know which of the strategies works better under different circumstances because it seems they’re good for different things, but how would you know?
Luciano Siracusano: Well, I would say from history there is a particular environment where fundamentally weighted doesn’t work very well and that’s in a market bubble, it’s in an environment where stocks have expanding P/E ratios and where very highly valued stocks get very large weights in cap weighted index, so the strategy would not do well at the top of the tech bubble in the US in 2000 and it wouldn’t have done well at the top of the Japan bubble in 1989 international markets, but that’s also the vulnerability of a cap weighted index. If you’re looking out at the world and you’re a sophisticated investor and you realise that the country weights in the cap weighted index, the countries are trading at very high P/E ratios, that’s a red flag, there’s risk in that portfolio and that’s probably the opportunity or the time to look at the fundamentally weighted alternative because the fundamentally weighted index is going to concentrate away from where the valuations are highest.
Evan Cooper: And Dodd, what’s your view on that?
Dodd Kittsley: The conversation has been great in terms of really bringing out, you’ve got to do your homework, you’ve got to understand what you own and you certainly do need to do your homework in terms of understanding how particular strategies would do in an expected economic environment, market environment going forward, and a lot of history can help illustrate that. Evan, to answer your earlier question of, what is a category within this alternative beta that has been working and has been something that investors have been using quite a bit; low volatility strategies, minimum volatility strategies. They have grown from $7 billion at the beginning of the year to now $13 billion, and the numbers aside, the reason why they’ve been so popular with investors is because they address a particular concern. Getting equity market exposure but doing so in a more risk controlled thoughtful way, and I think that really does highlight that, hey, if you’re concerned about volatility, being able to screen for lower volatility stocks, be able to build a portfolio that creates a smoother ride, if you will, is something that I think is a good illustration of how this works and where it’s resonating with advisers.
To also build on another point, understanding what you own even within the minimum volatility or low volatility category, the different approaches can lead to very, very different types of exposures. For example one index essentially takes an opportunity let’s say the S&P 500 and just ranks stocks from the highest to lowest volatility and takes the low vol stocks, doesn’t really control for sector overweights or underweights and as a result investors can have a very high exposure to things like utilities, which when you look under the hood may not be your intended exposure. Other index providers can provide and actually have controls for massive overweights and underweights relative to the market, so doing your homework both in terms of identifying the strategy that’s most appropriate and then more importantly really going into understanding what your options are and what the different index methodologies offer you is really the key here.
William Belden: Evan, I think you started by asking how do investors know or what their expectations are, I think that every investment manager provides an abundance of risk disclosure and starts with past performances, no guarantee of future performance, but I think going back to some of the statistics that Dodd cited here at the outset point too is that the more history that’s put on the board, the more performance that’s demonstrated and as we go through market cycles the more evidence there is of how certain smart beta or alternative beta types of strategies will perform in different market environments. And as investors get increasingly comfortable that in the face of what they expect to be the market environment going forward, that a particular strategy will behave in a certain manner because it has behaved that way in the past, helps shape what they believe will happen going forward.
Tony Davidow: Can I just pick up on something that Dodd made I thought an excellent point on, even low vol strategies are different, fundamental strategies are different, low vol strategies are different, so I made the point earlier and maybe just to be clear to advisers listening on this programme, because the reason we’re doing this is we feel there is a need for education, is I think advisers really need to start by understanding what is the methodology, understand the methodology, understand the index construction. And then the by-product of that when you peel back the onion and you look at it, look at things like what’s the large, mid, small value tilts that exist, or mid, small tilts that exist and what you’ll find is some of these strategies have a pronounced small cap effect, that’s where they get their excess returns. Look at the value growth tilt and what you’ll find is fundamental strategies typically have a value tilt. They’re not value strategies and in fact we’ve seen by our evidence as Luciano referred to, they actually do perform well in growth cycles, so they’re not value strategies.
But to Dodd’s point earlier, then strip it down and look at the sectors, and we’ve actually gone through that exercise and I know exactly what he’s referring to because a very popular low vol strategy has a 30% allocation to utilities and a 22% allocation to consumer staples. We’re not saying it’s right or wrong, in some environments you’re going to be rewarded for that, but I think a lot of times advisers are following the returns, they’re looking at the returns and they’re saying, I want to buy the most attractive one based on the risk/return profile, but if you peel back the onion and you understand the source of those returns you actually might make very different decisions over time, and I think that low vol discussion is an interesting one.
Luciano Siracusano: And I think the other important piece to focus on is correlation, so the correlation of the index to the benchmark so you have some sense of how closely is it moving with the market, particularly if you’re trying to use it to capture the returns of an asset class and that will allow you to actually do the analysis; what was the risk adjusted return, what was the Sharpe ratio, what was the information ratio, because there’s always a trade-off. You can pick low volatile stocks, bring down risk and volatility but you may not get the upside potential of the market, you may be leaving a lot on the table. So you have to come back at the end of the day and say, what was the return, what was the risk and what’s optimal, and to the extent you’re over concentrated in sectors or over concentrated in particular countries you may not get close to the return of the market because you concentrated the bets too intensely.
Evan Cooper: So I want each of you to disagree with me or say where my reasoning is wrong. It seems that what you’re saying is that by previous long-only strategies somebody would invest in the stock market and hopefully it’ll go up so everybody makes money. This is much more of a predictive bet saying, based on the construction of these indexes and based on my view of what the future may be, this would be the good place to be, so this is the best way to get that, the closest to what I think is going to happen or benefit from what I think is going to happen. So, using alternative strategies and alternative beta, indexing and funds based on it, would be very helpful if you had a very clear view of the future or that may not be correct, but at least a clear assumption of what the future will be and then use these as tools to get there. But it’s not automatic like, okay, let’s put it on index and then just see what happens, it’s more having some kind of forecast of what’s going to happen. Is that true or not true?
Luciano Siracusano: Well, it’s tricky. I start from the premise that I don’t know what’s going to happen in the future. All I know is I want to get globally diversified and I want to get globally diversified across asset classes and the question is; what’s the best way to get exposure to the asset class. Should I use an active manager who’s going to make the choices for me or should I use the cap weighted index, or do I take a risk if I use the cap weighted index because there might be too much volatility in there, and I think that’s where the alternative smart beta comes into play; it’s somewhere between active management and traditional passive and it’s on a continuum probably closer to traditional passive, because it’s rules based, it’s transparent, it’s typically low turnover, low fee and replicable. Most of these strategies don’t depend on whether or not their principals are at the firm the next year. The rule set is defined. So I think what you’re really saying is you don’t know what’s going to happen but you want to have the exposure, you don’t think cap weighted is optimal and you think there’s a flaw in cap weighted, that maybe one of these smart beta approaches can correct for and in some cases you would substitute your cap weighted exposure, sometimes you’d use that smart beta as a complement.
Evan Cooper: And Tony and then I want to get to Dodd too.
Tony Davidow: Yeah. No, I think that I would just pick up on one aspect of that and that is that all of the providers of these smart beta strategies are giving you better tools. They’ve grown out of this feeling that you can improve on the experience, but ultimately the adviser is really making that decision. We actually do provide some guidance on how you should allocate across market cap fundamental and active strategies, but at the end of the day if you strip it down the adviser can make a better informed decision. To your comment earlier, if the adviser has the view that the world is going, everything is going to be rosy tomorrow morning, we’re going to have a budget and everything’s going to be great and they feel good about the market, then they could make a better informed decision if they knew what they were investing in and how they were getting the exposure. But I think the naïve way is to say, well, let me just buy something and I have seen this very attractive risk adjusted return over the long run. But I think the beauty of these strategies is they’re better building blocks and now with a broader array of solutions, that adviser can make a much more informed decision going forward.
Evan Cooper: And Dodd, what’s your view on this idea that smart beta or advanced beta techniques really require somebody to have a clearer view of what they think the future is going to be, or have a clearer perspective of what the market is going to perform?
Dodd Kittsley: Yeah, I think that they absolutely do resonate with investors that do have a particular view on the market, they do want to take an increased or decreased exposure to particular factor or quality, whether that be low volatility stocks, whether that be high quality companies, whether it be small cap over large cap. I think the diversity of exposures that we’re talking about here though lend themselves to a very broad range of investor types and objectives, ranging from momentum ETFs that could be used very tactically and short term to take advantage or hedge away some risk with an upward trending rapidly moving market, to things like minimum volatility again or dividend strategies that arguably could be used very strategically from a very long term perspective by buy and hold investors. So again, I think Evan you bring up the right point here, you’ve got to know what you’re owning, you’ve got to be able to articulate your view relative to a market cap weighted index, and if you can do that and identify the product that best reflects that view, these are incredibly valuable tools.
Evan Cooper: Bill, do you want to add something to that?
William Belden: I would just say I think we’re striking an interesting balance between, going back to what I was talking about earlier in terms of portfolio construction and having that portfolio positioned optimally to meet the investment objective that each investor actually has. So Dodd talked about a long term buy and hold investor who is perhaps saving for retirement and will have his adviser construct a portfolio in conjunction with that objective versus someone who is much more tactically oriented, and we’ve found that these types of strategies are very effective in expressing a specific view on the marketplace that can be a little bit more dynamic in nature. So, you may choose to employ some assets or allocate some of your portfolio to something that you expect to provide an attractive return over a 3, 6, 12 month investment horizon, which will dramatically differ from a portfolio that you’re actually implementing to meet your retirement needs which are 10, 20, 30 years down the road.
Evan Cooper: I wanted to bring up a point Luciano made earlier about this is on the spectrum between active and passive but still passive. In terms of cost is it more expensive typically, are alternative beta strategies more expensive than traditional market cap weighted indexes or by how much or not at all?
Luciano Siracusano: Well, I would say if you’re using a commoditised cap weighted index where there’s competition in the industry and there’s different ETF providers based off the same index the fees can be very low, they can be less than 10 basis points. For fundamentally weighted we’re typically 28 to 38 basis points in the US, 48 to 63 internationally, so more expensive than commoditised cap weighted, less expensive than active managers. And we always let people know that the expense ratio of the management fee is paid out of the dividend income that is collected, so if you have a dividend weighted index which starts with a dividend yield above the market, after that dividend yield after fee you might actually be cheaper than some of the competition. So, I think having a holistic view of what is the price you’re paying to access a strategy is very important, and for anyone who is not using a cap weighted index at the end of the day, the test is did you beat the cap weighted index after fees, after expenses and after transaction costs, and if you haven’t there’s probably not a good reason for being for your product.
Evan Cooper: And Tony, did you have any comment on that?
Tony Davidow: No, I was just going to add they’re more expensive but they’re definitely more cost effective than your typical mutual funds or active managers, and I would also argue you get what you pay for. So if you look at, most of the research suggests somewhere in the neighbourhood of 200 basis points of excess return coming from these alternative weighting strategies, some more, some less, depends on the market environment, but if you’re getting 200 basis points of excess return I think you can afford to pay a little bit higher fee to get it. And I agree with Luciano, and our positioning is these are on the spectrum between true traditional passive strategies and active, because you really do capture the best elements of both, and one of the comments that Luciano made earlier that we shouldn’t gloss over is rebalancing actually adds a significant portion of that excess return. If you believe the markets revert to the mean over time, that rebalancing allows you to capture that, and all of these non-cap weighted strategies that rebalance benefit from that.
Evan Cooper: And let me just ask, the tax consequences of this, are they different from a market cap weighted index in terms of?
Luciano Siracusano: I would say if you were in the mutual fund structure having higher turnover it could potentially be an issue, but because we’re talking today about ETFs that attract these indexes, we’re benefiting from the ETF structure which has a mechanism under the hood which makes it very, very tax efficient. Many of the equity ETFs don’t distribute capital gain distributions and some of those ETFs are tracking indexes that have 50%, 75%, 100% turnover a year, so what may have been true historically for the mutual fund industry not necessarily true in the ETF industry because we just think you’re fundamentally dealing with a better structure.
Evan Cooper: And Dodd, do you have any comments on that about the structure itself benefiting investors?
Dodd Kittsley: What Luciano brought up is a really, really good point there. The advantages that ETFs offer aren’t just limited to passive market cap weighted indexes and the fact that most fundamentally weighted strategies, alternatively weighted strategies have more turnover I think was a good test for ETFs in terms of does the structure work; does exchanged traded funds in this structure really reduce capital gains distributions and deleterious effects there, and the answer is a resounding yes.
The other thing just to carry it a little bit further, it’s more than just expense ratio, it’s the overall liquidity that ETFs offer in enabling investors to be able to access intraday liquidity, be able to name their price, have flexibility, as well as the advantages that ETFs offer in terms of just transparency; you know what you own. In other structures that type of precision, that type of peace of mind of understanding your overweights, underweights and exposures isn’t as much, so don’t underestimate the advantages that ETFs offer and I think this was a great test for the industry and one where exchange traded products really passed with flying colours.
William Belden: I think the tax efficiency question is very timely too as managers prepare to announce what their capital gain distributions will be for the year. We’ve obviously been in a very bullish market environment for equities and now active managers are going to be announcing some gains, and they don’t have the losses that they had a couple of years ago to offset those gains, and if ETFs continue to deliver the tax efficient performance that they have I think that that distinction will become that much more evident out of this year.
Evan Cooper: Let me get back to a point that Tony made earlier about allocations and how much of this should an investor have, obviously it depends on their time horizon and their investment goals and all that, but where does this fit into a portfolio typically or what is Schwab saying about that, where this fits?
Tony Davidow: Well, I think everyone varies a little bit, but we do have a view that in the most efficient markets we would allocate more to fundamental strategies relative to market cap or relative to active managers. In the less efficient markets we think there should be some skill to be had so we wouldn’t say broad based universe, but we would say that if you can identify superior managers who deliver very strong excess returns but superior downside capture ratio that’s where you’d be allocating more to those managers in the less efficient markets. We would always allocate more to fundamental relative to market cap. In the domestic markets our highest allocation percentage would go to fundamental strategies, and then in the least efficient markets we do believe there’s some skill to be had if you can identify managers with better downside capture ratio. And we also have developed a series of levers that help individual investors think about how to make those decisions, realising all individual investors are different. So, if your primary goal is to minimise your cost you would probably allocate more to market cap strategies, if you were very concerned about tracking and being different than the market experience you probably would allocate more to market cap strategies, you’d avoid fundamental strategies, because even though I would argue it’s an apple to orange comparison you’re going to exhibit a higher tracking there. But if your goal is getting that excess return and better risk adjusted returns as Luciano referred to, I think that’s the role of fundamental strategies and it’s been pretty persistent across market segments and up and down the cap spectrum, so we believe that that’s the role they have and we believe that combination helps in minimising the volatility and smooth the ride.
Evan Cooper: And Luciano, what about you, what’s your view on how much of this?
Luciano Siracusano: I think investors and advisers should be exploring the core, I think they should explore the core of their portfolio to see if it’s possible to add alpha, not at the periphery but in the core of the portfolio. Particularly if you’re looking in the US and you’re looking at US mid cap, US small cap, if you get to the point where you think some of the P/E ratios are too high on the cap weighted index it’s a great time to switch into a fundamentally weighted approach that rebalances the market once a year. In the case of the earnings weighted family when we weight and weight by earnings we lower the P/E ratio of the entire small cap market. When we weight by dividend we raise the dividend yield on the market relative to cap weighted. So for advisers who are trying to generate dividend income for clients in retirement a dividend weighted approach makes a great deal of sense. It’s something with WisdomTree that you can apply globally, you can do it across the world; it’s not a niche approach. You can dividend weight developed markets and we have. You can dividend weight emerging markets, and you can generate more dividend income into the portfolio and in many instances lower the downside capture and reduce overall volatility.
So I think it has a very, very broad approach, very, very broad application and that’s compared to traditional indexes. You can also use this as opposed to active managers. The dirty little secret is with active management you have to go into emerging markets, buy and sell the stocks at bid-ask spreads, handle all those transaction costs and trade a lot in order to try to beat the index. That creates a tremendous drag on the portfolio. The ETF typically doesn’t have to bear those costs because the securities in many cases are delivered through the ETF manager through the authorised participants who are buying them in the baskets, delivering them to the fund company. And so we’re at a structural advantage, not just on taxes, but in terms of how the actual securities are purchased and sold and so over time I would imagine ETFs doing very well against the active managers internationally in emerging markets, particularly those who have five and ten year track records.
Evan Cooper: And Dodd, let me ask you that, the same question; where does this fit given the fact that individuals have different investment objectives and time horizons, but overall where does an advanced beta strategy fit into someone’s portfolio, how much of it should be there?
Dodd Kittsley: It’s a great question. I think at the heart of the matter is what these strategies have done, what the exchange traded products have done delivering these type of strategies has just made the toolbox bigger and it really is driven by an investor’s objective, the time horizon and what their view is on the market. It’s just it’s another way of building portfolios in a more thoughtful, efficient way. You can go passive with market cap weighted indexes, you can reflect a particular view with alternative beta type of strategies, so long, again, as you can articulate what that overweight and underweight you want to use, and then you can go full active as well in other types of strategies depending on your level of conviction in a manager to deliver alpha. But this part of the market is so exciting because it is that kind of sweet spot between beta and pure manager discretion in alpha seeking type of strategies that has so much merit and can add a lot to an investor’s portfolio, whether again it’s an institution tweaking a particular factor in moving their portfolio up or down a percent to reflect a view on momentum in the market, or view of quality of companies to a long term buy and hold investor that wants long term exposure to dividend payers, dividend growers, or more volatility controlled portfolios. So, we see the application is incredibly broad but it delivers something different and something that is really compelling to the investment landscape that I think investors are just really beginning to realise.
Evan Cooper: And Dodd, you made a good point in that it seems in many of these, from what everybody has been saying through the discussion, is that institutions probably would find this more intuitively appealing, not more than investors but at least they have the objective set forth maybe in an articulated way more than an individual might, so this would appeal to them because they could find something that matches exactly what their investment objective is. Is that true, so among institutions has this become a more popular way of investing because they can match exactly what they’re looking for?
Tony Davidow: I think the institutions drove a lot of the innovation and the demand, but the beauty of this industry, and we can’t underscore enough the importance of the ETF structure, is a lot of those great ideas are now translated into a vehicle that’s easy for the average investor to get exposure to, so a lot of the heavy lifting was done by the institutions challenging the index providers to build these strategies and then most consumers today can very easily get exposure to it.
Evan Cooper: Bill.
William Belden: Yeah, I think that to echo Tony’s point, the institutions really were pushing towards outcome oriented types of strategies and so I think that they were the origins of alternative weighted indexes back originally in the ‘70s and it’s really been the synthesis of that into a consumable product at the retailer or the adviser level that’s been at the crux of the development that’s led to the asset growth that Dodd talked about earlier.
Evan Cooper: Luciano?
Luciano Siracusano: Yeah, I would agree 100%. Back in the ‘80s when Japan had a huge multiple in a bubble the institutions were asking for an international exposure that was GDP weighted, that was not cap weighted, so they were one of the early advocates of it. Goldman Sachs ran an earnings weighted index in the early ‘90s on the institutional side, so I think there’s been some awareness for some time that as good as indexing is and a lot of institutions use it because it’s such a low cost approach, it may not be optimal, and the flaw is how it performs at the top of markets and the kind of risk it subjects institutions to when valuations get stretched.
Tony Davidow: Could I just introduce one point and that is, we haven’t really talked about it but I’m sure that a lot of the people who are listening to this do use active managers. I think Dodd mentioned it and I mentioned it briefly, I would argue there still is a role for active managers. I think clearly the ETF industry has benefited from a lot of active managers and their inability to outperform over time, but I’d argue that one of the great roles of an active manager is the ability to play defence and again I talked earlier about downside protection and how important that is. We love these index based strategies, but by definition they really can’t alter what they do, so if we’re to have an exogenous event or something happens where you want to either get more defensive or pull out of the market altogether that’s a lot of the value that the active managers play. So for those who might be thinking, are we predicting the demise of active management altogether, I for one don’t believe that’s the case, I do believe there’s a role for them, and as much as we love these strategies there are limitations.
Evan Cooper: But we were talking earlier though, given that there may be some limitations, but what are the institutions, you talked about institutions driving this, what are the institutions looking for now, what’s on the horizon perhaps, what other kinds of new wrinkles could there be in active beta strategies? Dodd, what are institutions coming to you with and saying, make something like this?
Dodd Kittsley: Yeah, the factors again I think are really something that has resonated on the institutional side and actually BlackRock partnered with an institution to bring many of these products to market because they had an immediate demand of being able to get exposure to quality and momentum and in value. If you think back, the capital asset pricing model is a single factor model, right, there was an effort for institutions to be able to attribute stock performance to general overall market moves, but many sophisticated investors today are using multivariate risk models where they can explain stock performance based on a lot of these different types of factors, and now institutions do have that ability to be able to again tweak and reflect an overall portfolio of individual stocks and securities with an ETF to bring into line their view on several risk factors that they pay attention to every single day.
Luciano Siracusano: I’d say one area we’ve seen a lot of interest is this whole notion of hedging out the currency impact of your international equity exposure, so WisdomTree is a leader in the industry in terms of creating equity portfolios that mitigate currency risk, hedge out the euro, hedge out the yen, hedge out the British pound, so we’ve seen a lot of adoption of that. The other area I think where they use this are hard to reach parts of the globe where access is not too easy. For a long time you really couldn’t go into India and buy the local securities, we were the first company to put it inside of an ETF, the local Indian securities. Emerging market small cap, Japanese small caps, European small caps, parts of the market that are difficult to access work very well in an index based ETF structure and we’ve been having a lot of success with those strategies.
William Belden: I would add that one of the other headwinds that I talked about earlier that investors are facing is diversification of income sources, and obviously the interest rate environment being what it is institutions are seeking income sources as well in many cases, and diversifying the sources of that income or finding higher sources of income I think has been a challenge, and so we’ve talked and worked with some institutions around creating multi-asset strategies that deliver income sources that are consistent throughout market cycles. And I think that with institutions focused on LDI, liability driven investing, they want greater assurances that they can actually achieve their income needs to meet their own obligations and so are diversifying away some of what some of their income sources have been in the past has been an objective of theirs that we work with them on.
Evan Cooper: And are there any advanced beta ETFs that go into the fixed income space, talking about, concentrating on equities, but given all the turmoil in the fixed income markets, anything that’s designed to?
Tony Davidow: I was going to say that I think that’s the next area, so you’ll start to see fundamental in fixed income which makes an awful lot of sense. It’s difficult to do, that’s why you haven’t seen them yet, but you’ll start to see strategies there as well as commodities. So, we know where we’re not going to go because although big style boxes are already covered and market cap is certainly represented I think the challenge becomes, does it make sense in the sector of the market that you’re looking at, these fundamental alternative weighting strategies, so I think a lot of the research suggests that and then it gets a little bit more tricky when you think about how to implement and how to get exposure. Fixed income is still relatively new in the ETF land just because of the way the markets are, the institutional markets are not necessarily replicating the Barclay’s acc. So I think that is certainly an area of growth but I would hope that whoever gets to the market gets to the market when they know they can do it well.
Dodd Kittsley: Yeah, to add onto that I would completely agree. We think at BlackRock fixed income will continue to be an engine of growth for the ETF industry but that isn’t just in traditional asset weighted indexes and we’ve already seen some significant growth on the other side of the continuum on the active side, we think that the promise for active within fixed income is strong but as is a type of fundamentally alternatively weighted type of product. We’ve seen some in Europe already in terms of interest rate hedged types of exposures. I think that is the future and again be able to reflect a view that folks have on fixed income where it’s going to be a challenging environment with rates going higher, and for folks to be able to reflect a particular view, the promise is huge.
Evan Cooper: Well, we’re getting to the top of the hour. I just wanted to have everybody give a takeaway, something that investors and advisers could, sort of encapsulate everything we’ve said, if we could, in a short takeaway of this. So, Luciano let’s start with you, what should investors and their advisers, institutions come away with when thinking about advanced beta strategies?
Luciano Siracusano: I would just say, similar to how you wouldn’t use one active manager to manage every asset class in the world for you; you probably shouldn’t use one indexing strategy around the world for every passive approach you want to take. If cap weighted is not optimal it means you may be leaving 100 to 200 basis points a year of market return on the table, and all I would say is if you’re open to it and you don’t have 100% conviction cap weighted is optimal, look around the world, because today there is a fundamentally weighted alternative, to pretty much every market in the world you could use a fundamentally weighted alternative. And the second point I would just make is that at the end of the day what matters is the return you get and the risk you get and all of the stuff is quantifiable and there’s enough of a real time track record now to start making meaningful comparisons in real time to what was established, and I think the debate is changing because there’s seven or eight years now of real time records at the index level and at the fund level after the fees and transaction costs.
Evan Cooper: Tony?
Tony Davidow: We think these alternative weighting strategies are terrific but like everything we encourage advisers to spend the time, understand them, understand the methodology, understand the index and then peel back the onion to really take a look at what are some of the bets that are introduced, what are the value growth tilts, what’s the capitalisation of these portfolios, are there sector bets and biases introduced over time and then I think it allows people to have better informed, better decisions going forward which leads to a better outcome.
Evan Cooper: And Dodd, your takeaway?
Dodd Kittsley: Exchange traded products have grown to $2.1 trillion in assets and there’s a reason for that, it’s because of the advantages they offer. I think the important thing that we’ve talked about today is ETFs aren’t just about indexing, they are about delivering the most efficient exposures to investors and alternatively weighted types of strategies fall into that bucket and investor dollars are going in that direction. $55 billion have gone into non-market cap weighted exchange traded products here to date, so if you’re not looking at them as an investor you should, because it certainly expands your toolbox and can create more efficient, better portfolios.
Evan Cooper: And Bill, we’ll let you have the last word.
William Belden: Well thank you. Again I think just building off of Dodd’s comments, I think we’re only in the second inning of this alternative or smart beta indexing history, if you will, so very strong flows right now and just we’re on a cusp of, I think, really breaking out as adoption rates continue to increase. We bought the first alternatively weighted ETF back ten years ago with the equal weighted S&P 500 and so it’s a core of what we do at Guggenheim in our ETF product line up. And to Tony’s point, knowing what you own and understanding how it can enhance the returns that you are positioned to achieve as an investor or an adviser, I think really is the key of how quickly and what the pace of that adoption rate actually is going forward.
Evan Cooper: Well, that’s terrific. I think we’ve learned a lot more about alternative beta, about advanced beta, smart beta, and plain vanilla beta too, but gentlemen thank you very much for your comments and we look forward to seeing you again soon on another Masterclass from Investment News and Asset.tv. Thank you.
Important Information
The sources, opinions and forecasts expressed in this interview, which are subject to change, are as of October 2013 and should not be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product and it should not be relied on as such. The user of this information assumes the entire risk of any use made of the information provided herein. Unless expressly stated otherwise the opinions, interpretations or findings expressed herein do not necessarily represent the views of the WisdomTree or any of its affiliates. Past performance is not indictive of future results.
Luciano Siracusano is a registered representative of ALPS Distributors, Inc. WisdomTree Funds are distributed by ALPS Distributors, Inc.
Information and opinions contained in this interview have been arrived at by Guggenheim Investments. Guggenheim Investments and Asset.tv Ltd accept no liability for any loss arising from the use hereof nor make any representation as to their accuracy or completeness.
Any underlying research or analysis has been procured by Guggenheim Investments for its own purposes and may have been acted on by Guggenheim Investments or an associate for its or their own purposes.
Information and opinions contained in this interview have been arrived at by Schwab Center for Financial Research®. Schwab Center for Financial Research® and Asset.tv Ltd accept no liability for any loss arising from the use hereof nor make any representation as to their accuracy or completeness.
Any underlying research or analysis has been procured by Schwab Center for Financial Research® for its own purposes and may have been acted on by Schwab Center for Financial Research® or an associate for its or their own purposes.
Information and opinions contained in this interview have been arrived at by BlackRock. BlackRock and Asset.tv Ltd accept no liability for any loss arising from the use hereof nor make any representation as to their accuracy or completeness.
Any underlying research or analysis has been procured by BlackRock for its own purposes and may have been acted on by BlackRock or an associate for its or their own purposes.
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