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Richard Hannam and Niall O'Leary share insights into building an advanced beta equity portfolio.
Bookmarks:
0|Advanced Beta
62|Advanced v Traditional Beta
108|Investor interest
188|Benefits of rules-based strategies
221|Experienced passive management
352|Advanced Beta fixed income
531|Advanced Beta Equity
643|Investment Horizon
782|ETFs
878|The future for advanced Beta
Duration:
00:16:54
Recorded Date:
16 April 2013
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Presenter: The popularity of advanced beta strategies continues to rise. With uncomfortable levels of volatility ever present and an uncertain economic climate, investors are recognising the potential of strategically tilting portfolios to enhance overall returns and also to lower costs. Today we’re speaking with Richard Hannam for some more insights into building an advanced beta equity portfolio, and he’s joined by Niall O’Leary for perspectives on advanced beta in the fixed income arena.
State Street Global Advisors is one of the largest index managers in the world with some $1.4trillion under management according to Pensions & Investments, and last year it saw advanced beta assets jump to $38.6billion, that’s an eightfold increase from the $4.5billion it ran in 2008. Richard, advanced or smart beta, how does it differ from traditional beta?
Richard Hannam: Well before I get into the differences I’d like to say we at SSgA don’t like the term smart beta, because of the implication it has for cap weighted indexing, which has been around for an awfully long time and we don’t think will be going away anytime soon. That’s why we prefer to use the term advanced beta. In terms of how it differs, you know, the cap weighted index is a very simple construct, it simply has the largest weight for the largest companies, and what we’re really talking about here are different weighting schemes that allow you to construct portfolios that are different to what you find in the cap weighted index.
Presenter: And what sort of clients are getting interested in advanced beta at the moment?
Richard Hannam: Well we’re really seeing this across our client base globally both in the equity and also in the fixed income space. There’s been an awful lot of research and evidence done over really the past 30 or 40 years that shows that certain factors or risk premium or attributes have been rewarded beyond sort of standard market beta. And what we’re now starting to see are managers and indices being created that allow investors to tap into those.
So for example there’s often been a lot of talk about a thing called the value premium. So the idea that over the medium to long term companies that have a low valuation do better than companies with high valuation. You can see that evidence going back to certainly the end of the Second World War in the US and to the late Sixties in global equities, and that’s very publicly available information, and so what’s now happening is strategies, whether they be designed by a manager or whether they be incorporated into an index, are now being created. They’re allowing investors to capture that very simply and very passively and therefore very cheaply into their portfolio.
Presenter: And what are the primary benefits of these rules based strategies?
Richard Hannam: Well, I think for investors that really have the chance to think deeply about it, it allows them perhaps to do something slightly different to just having their passive equities invested in a cap weighted manner. So if as a house or a pension fund has a belief that it’s better to be more in smaller companies than large ones then these might be more effective ways of actually capturing that within the portfolio that is being managed on their behalf.
Presenter: So are these rules based strategies an effective substitute for active management?
Richard Hannam: That’s certainly one way that people are using them. I think I would very much try to contrast for any investor thinking about this the difference between an active manager who is doing a great deal in terms of stock selection, they’re very dynamic perhaps in the way that they allocate to securities and the way that they’re looking at the underlying sort of drivers of return that they’re trying to capture in their portfolio, and these more passive or beta based approaches, which are much more systematic in the way they’re trying to capture the effect.
And I would say one of the concerns I now have and we’ve been talking about this for a number of years is we run the risk that I think there’ll be a bit of rebranding if you like where perhaps people with active strategies are suddenly calling things, you know, smart beta, alternative beta and that somehow makes them more beta like than in reality they perhaps are. And in my view clients that are interested in this type of investment approach should be dealing with those that are experienced in managing passive portfolios. Because when you actually dig down into creating or implementing a portfolio you really have two choices.
You can either track an index. So in a lot of these sort of new ideas now there are indices out there that you can track, and I would argue strongly that the best people to do that are the passive managers that have the skill and expertise to deliver portfolio returns that track their index very closely. The second group then are where perhaps the manager creates a tailor-made or quite bespoke portfolio strategy for the client, but again there’s a set of rules and a very passive based approach to the way the portfolio is managed on their behalf. Again I would see a passive manager as being the best people to do that, the people that are implementing most cheaply at the lowest possible cost.
Presenter: And how can advanced beta be applied to the fixed income space?
Niall O’Leary: Similar to the equity space traditionally fixed income benchmarks have been cap weighted, and when we think about sovereign bonds or corporate bonds that essentially implies that you are investing the most amount of money in the companies or the governments or the countries with the greatest amount of debt. And when we think about what we’re trying to achieve when we invest in debt instruments, we’re not trying to take exposure to those with the greatest quantity of debt, arguably we’d like to take exposure to those with the greatest quality, whether that’s a corporate or a government.
So as we start to see the move from equity to fixed income in the advanced beta space we’re starting to see strategies that look away from cap weighting and look at fundamental factors, such as debt to GDP ratios or the size of a country or fundamental factors perhaps in the corporate space.
Presenter: And does this approach work better with sovereign or corporate bonds?
Niall O’Leary: I don’t think it’s fair to say that it works better for one versus the other. I think what the financial crisis over the last number of years has shown is that investors have started to think about the traditional benchmark for fixed income. Where historically there was an assumption, a false assumption that developed sovereign bond markets were risk free, investors have started to realise that having exposure to all developed sovereigns just because they issue debt is not necessarily the appropriate way to consider it.
So definitely we’ve seen a move towards GDP weighted or other fundamental factors for sovereign markets, but we’re also starting to see some investors embrace the idea of advanced beta in the corporate space; again moving away from the companies that have the greatest quantity of debt towards those companies that have the greatest quality behind their debt metrics.
Presenter: So what are the main risks in a traditional bond index?
Niall O’Leary: If we think about it in its simplest format and think about say a sovereign bond benchmark and just for simplicity sake we limit it to the European market, if we look at the eurozone the crisis has been obviously very well documented this stage, and we’ve seen lots of different acronyms and terms used to describe those sovereigns that have suffered the greatest fall from grace through recent times, Greece, Ireland, Portugal, but also the ones where the question marks exist, such as Spain and Italy. And if we look at a cap weighted benchmark of eurozone government debt it might surprise people to see that Italy actually represents more of the benchmark than Germany despite the fact that the German economy is almost 50% bigger than the Italian economy.
Do investors want to have more exposure to a more indebted country with poor financial metrics and a greater quantity of debt outstanding or to a strong economy with good debt dynamics? And those questions are being asked and investors are opening their eyes to the probabilities and the possibilities associated with alternative weightings rather than just market cap weightings.
Presenter: Richard, given all that what sort of advanced beta strategies are particularly popular with clients at the moment?
Richard Hannam: I think for the last sort of two or three years most of the interest that we have seen have been in the sort of fundamental indexing space, so that’s the index that has been produced by research affiliates. So we’ve been seeing quite significant demand for that. And I think secondly in the low volatility space as well, clients looking for an equity like return but perhaps with less downside risk, so for pension funds in particular or insurance companies thinking about their liabilities that’s often a better place to be. So I would say predominantly in those two areas. But I think now as there are so many new indices coming out there’s a lot more things for people to think about.
So more recently I think the concept of quality has come a little bit to the fore, so thinking about those companies that perhaps have more consistency of earnings, have sort of lower debt to equity ratios, higher returns on assets, those types of things they tend to be the large blue chip type names. So again there’s been a little bit more interest in those. What you do tend to see is that some of these factors are quite closely linked. So the sort of quality, high quality and low volatility tend to go quite close together; there’s a strong correlation between the sort of lower valuation sort of securities and smaller companies; momentum as a factor tends to sit out there a little bit on its own.
So we’re trying to get people to think about what is driving the return on the index, how might this fit in with other parts of your portfolio and then to think about how you can construct a sort of passive answer to your problem as best you can.
Presenter: So is advanced beta about a series of long term investments or a basket of trading opportunities that investors can jump between depending on how they feel?
Richard Hannam: I think my preference is to think of them as a longer term opportunity. You know, if you look at the evidence of history you will see that over the long term these attributes or risk premium, these factor returns, they have been rewarded over time. So you are picking up a return premium from say smaller companies compared to larger companies, or companies with high momentum relative to companies with low momentum. But over short even sometimes to medium periods you do get underperformance relative to a cap weighted index.
So while I’m sure there’ll be people that will want to try and trade in and out of these things, and I’m sure people will develop products and solutions to enable clients to do that, most of the work that we’ve done at least with our passive clients is to get them to think about the sort of single factor or single risk premium exposures and to try and harvest those in a very sort of cheap, passive and relatively simple way. And again going back to what I said earlier that I think allows a differentiation against active management, which will tend to be much more dynamic.
Presenter: So, Niall, how long should somebody be looking to hold a fixed income advanced beta strategy for?
Niall O’Leary: When it comes to advanced beta I think there’s no timeframe that you can specifically define as appropriate for an investor. I think an investor really needs to be comfortable with the idea that advanced beta whatever way they weight their benchmark is the right way for them to have their fixed income exposure in the long term. In the sovereign space that might be GDP weighted; it might be some fundamental factor weightings. In the corporate space likewise I should say it should be maybe around fundamental factors. The idea of advanced beta is not that you trade in or out of it, but that you are comfortable with the exposures that you’re taking and you’re approaching it in a way that makes sense to you from the longer term.
Presenter: So it’s about knowing exactly what risks you’re taking and being happy with that.
Niall O’Leary: Knowing what risks you’re taking, taking them because you want to take them, and believing that that’s the approach that will serve your interests best in the longer term.
Presenter: And is it better to buy advanced beta through an ETF or a traditional index fund?
Richard Hannam: Well there’s certainly many less ETFs that you could use in the advanced beta space compared to traditional cap weighting, that is starting to change. There are more and more ETFs out there now that allow you to capture these exposures, but they still remain a relatively small part of the total market. I suspect that that will change over time. If you look at the institutional space, you know, passive investing, indexing in the sort of cap weighted form took off a long time ago. ETFs came along sometime after that and then they’ve grown quite dramatically.
The challenge I think for any manager or investment bank looking to create and launch these ETFs is there has to be enough of a market for it, and at the moment for many of these strategies they still sit really on the periphery of what most people are comfortable with. Probably the area where we’ve seen most interest is in the sort of dividend weighted ETFs, which really have drawn in a significant amount of assets, because people like the higher quality of dividends and the dividend consistency, and again historically it’s implied a sort of smoother path than you might have got from the cap weighted index.
So I think they’ve been quite popular with wealth managers in particular and with interest rates being so low, you know, people are looking for higher yield, and again I think that’s another reason why some of those ETFs have been very, very popular with more retail type investors.
Presenter: How’s advanced beta going to change over the next few years?
Richard Hannam: Well for me it almost feels like every other day there’s a new index out there that you could choose to track. So it’s becoming sort of more complicated I think for everybody to stay on top of all the things that are going on and all the potential indices that are out there. Most of what we saw initially started off as very much sort of single factor, i.e. focussing on low volatility, focussing on lower valuation, focussing on smaller size. What we’re now starting to see I think is a little bit more of combining of those trying to put two factors together. I think you will start to see more of that.
I think investors need to be very wary of over-engineering. That’s when you then get into the area of perhaps more active management. You know, if you can’t understand what’s going on sort of under the bonnet of whatever’s driving your engine, if you can’t figure it out, then be very wary of it. That’s one of the things that I would strongly sort of caution people to be wary of I think.
Presenter: Niall, a final thought?
Niall O’Leary: I think advanced beta in the fixed income space is years behind where we are in the equity space, and it’s only now as the financial crisis plays out and has played out and we’ve seen the impact on sovereign debt and corporate debt that we’re starting to see investors embrace alternative approaches to weighting fixed income exposures. Partly driven by the risks that they’ve been exposed to, but partially also maybe driven by disappointment with the performance that they’ve seen from their active managers around these crises. So I think advanced beta in the fixed income space both sovereign and corporate is a nascent part of the market, but I do think we’ll see it continue to grow over the years ahead.
Presenter: Niall O’Leary, Richard Hannam, thank you both very much.
Both: Thank you.
State Street Global Advisors Limited. Authorised and regulated by the Financial Services Authority. Registered in England. Registered No. 2509928. VAT No. 577659181. Registered office: 20 Churchill Place, Canary Wharf, London, E14 5HJ. Telephone: 020 3395 6000. Facsimile: 020 3395 6350.
This material is for your private information. The information we provide soes not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results. All data is sourced from State Street Global Advisors Limited unless otherwise stated.
The views expressed in this material are the views of Richard Hannam and Niall O’Leary through the period ended 20 April 2013 and are subject to change based on market and other conditions.
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