State Street Global Advisers has put out a “Complete Guide to Smart Beta.”
A preface by Lynn S. Blake explains that the focus of the paper is not on equity products but on “exciting new developments in the fixed income world.”
Within that space, multi-factor strategies will proliferate going forward. The idea, as Blake puts it, is to “combine key factors, such as Quality and Low Volatility, [in order to] provide enhanced performance and diversification benefits.”
The paper proper starts with the observation that there are five factors/exposures that are generally accepted in the literature as outperforming the market capitalization benchmarks: value, size, low vol, quality, momentum. The authors take us through each of them, beginning with their now established meaning in the equity realm.
Value. Over the long term, cheaper stocks outperform the expensive ones.
Size. The smaller cap stocks outperform the higher cap ones. An equally weighted index captures this insight automatically in its performance vis-à-vis a cap weighted index.
Volatility. Tilting toward lower volatility “can likely create a higher risk-adjusted return than traditional financial theory would suggest.”
Quality. Higher quality companies are (one might say definitionally) better at generating risk-adjusted returns. Quality for these purposes includes high profitability, earnings consistency, and no more than sustainable levels of debt. This notion of quality is what Benjamin Graham promoted in the 1930s.
Momentum. Theory notwithstanding, stock performance is not like coin flips – issuers that have done well recently will likely carry on doing well in the near term.
Momentum, though, as the paper also acknowledges, is a tricky effect to capture through an index. Momentum runs out pretty quickly, which means there is a high turnover in any effort to invest in whoever is the high-mo stock of the moment, and THAT means that transactions costs are high.
SSGA says that “the three attributes that resonate the most with long-term investors are value, low volatility and quality.” Fortunately the correlation among these factors is low, so they may fruitfully be combined in a multi-factor approach. Thus far, it has done most of its work on multi-factor investor in the developed markets, but it is now “exploring the same methodology in Emerging Markets” and the first results are positive. There is evidence that the familiar factors operate there, and that a multi-factor approach may be a fruitful one there as well.
As noted, the Smart Beta approach has long been associated with equities. This has been true since Benjamin Graham’s day – though he did not employ 21st century terminology for it.
SSGA, though, says the time has come for fixed income Smart Beta. Why? Because of:
- “The challenge of investing in a post-AAA world” where sovereignty doesn’t banish risk;
- The danger of excessive concentration otherwise;
- The growth of screened strategies in fixed income, and;
- Disappointment with active management.
The understanding of the factors derived from the world of equity needs some adjustment. But consider size as a factor. Is it still a factor in the fixed income world? SSGA suggests that it is. Among sovereigns, traditional cap weighted indexes will naturally be most heavily weighted toward the countries with the most bonds outstanding – which are of course the most indebted. The size factor means re-working the index with this in mind, by using bond investor friendly ratios.
SSGA tells us near the end of this Guide that “tilt investing is one of the more popular approaches” in smart beta. This is an intermediate strategy between traditional market exposure on the one hand and “more aggressive, higher tracking error Smart Beta strategies” on the other. As one might expect from an intermediate strategy, potential underperformance will be lower when compared to the full-throttle version of Smart Beta, and potential outperformance will be more limited. It is Smart Beta for people and institutions who don’t yet trust Smart Beta all that much.
For investors interested in going this route, SSGA will “tilt the weight of stocks in a cap-weighted index based on the factor characteristics of the constituents – ultimately increasing the tilted portfolio’s exposure to the desired factor(s).” It has a proprietary approach that involves the use of a number of sub-portfolios to do the tilting. The sub-portfolio system reduces the influence of any outliers and provides a framework for customization.
Tilting through such a system is, the paper concludes, “a useful addition to the investors’ toolkit,” preserving liquidity, investment capacity, and turnover characteristics similar to those of the broad underlying index.