Monday, March 12, 2012

Investors Chasing 'Smart Beta'?

Brendon Maton of the FT reports, Low or no returns send investors chasing ‘smart beta’:
Investing for market returns via index tracking strategies is standard for many investors. But given the current low level of market returns, or beta, interest is increasingly turning to more sophisticated index-style approaches often labelled “smart beta” by the investment industry.

According to Northern Trust, 51 per cent of investors globally are interested in exploring these strategies to meet their objectives.

Smart beta offers the opportunity to profit from alleged systemic anomalies, such as the superior efficiency of low-volatility stocks. It often takes the form of alternatively weighted indices, using factors like sales, earnings, book value, cashflow or dividends rather than market capitalisation.

Smart beta is a kind of index, but because the anomalies can be exploited in various ways, it can also be categorised as an active strategy.

So, for example, prospective clients of Paris-based Tobam can access its capabilities via segregated mandates, commingled funds or a series of indices devised in partnership with FTSE. Yves Choueifaty, Tobam’s founder, says there are only a few differences between the indices and funds, such as the frequency of rebalancing and an input of responsible investing in some of the funds.

If the formula is little different between Tobam funds and FTSE/Tobam indices, this begs several questions: when is an index an index and when is it a strategy, and how do investors choose between FTSE’s smart betas licensed from quant houses and those it has developed itself?

The conundrum is evident in the oxymoron “strategy indices”, used by many practitioners and agents as synonym for smart betas.

“The key benefits of index investing are simplicity, transparency, low cost,” says Dimitris Melas, head of new product research at MSCI, an index provider. “Therefore, strategy indices should have a clear objective, a transparent methodology, simple portfolio construction rules, and relatively low turnover.”

“Any strategy that does not have a clear objective or changes its objective over time, that has an opaque methodology, that relies on complicated portfolio construction rules, or that has high portfolio turnover making it difficult to replicate at a low cost, should be viewed as an active strategy.”

Unfortunately, there are no universally agreed definitions of “simple”, “transparent” or “opaque”. Mr Choueifaty, for example, claims his group’s methodology is there for all to see in applications for the intellectual patents that protect the business. Mr Melas says even with a PhD in mathematics he struggles to understand the Tobam formulae.

Meanwhile, MSCI’s Minimum Volatility index had a higher turnover in several years than Robeco’s minimum volatility funds, exactly the kind of strategy the MSCI index was designed to benchmark. Does this mean that MSCI Minimum Volatility, with a relatively high turnover, falls foul of Mr Melas’s own definition?

Mr Melas admits that MSCI Minimum Volatility is an attempt to represent a strategy and as such includes criteria (such as caps on size and turnover) that are variable. Richard Hannam, European head of passive equity at State Street Global Advisors, reckons that as MSCI Minimum Volatility has fewer than 300 constituents versus 1600 for MSCI World Equity, it ought to be considered a strategy.

The oldest smart beta house, London-based GWA, has 22 indices licensed via FTSE. GWA founder David Morris says: “We can index anything in the world but my bugbear is when folk claim these new indices are passive. [An index weighted by] market cap represents the full opportunity set and anything else is active.”

Indicative pricing confirms that smart beta sits between passive and active. Strategy indices managed under licence cost between 10 and 15 basis points for a €100m mandate. Direct from the quant house itself, the strategy would be 30-35 basis points. Providers such as Edhec-Risk Indices & Benchmarks do the former only. Businesses such as Acadian, Analytic Investors, Robeco and WisdomTree only tread the second, traditional route. GWA, Research Affiliates, Tobam and Westpeak do both. The big passive managers such as SSgA and Northern Trust will customise any smart beta a client wishes for as well as manage licensed strategies. US-based WisdomTree packages its strategies exclusively as exchange traded funds.

Pimco, the world’s largest commercial bond investor, has taken a singular route, bypassing index providers altogether for a new series of indices against which it actively manages assets. The new indices cover a fraction of Pimco’s total client assets but Mr Melas makes the point that if asset managers follow the same route as investment banks, which create proprietorial indices for every new business opportunity, the fear of conflicts of interests arise.

Clients – at least those with billions to manage themselves – do not seem bothered for the moment. Mr Choueifaty recalls that the origin of his group’s series with FTSE was the desire of a huge institutional investor to access Tobam’s intellectual property but in a customised manner and run by the client’s in-house team. Historically, the largest clients got segregated mandates with a direct line to the portfolio manager and the most attentive client liaison. The nature of smart beta means sovereign wealth funds can devise their own bespoke index without any expectation of sharing it.

Few, however, predict the end of market-cap weighted indices. Smart beta specialists such as Pim van Vliet, portfolio manager of Robeco’s Conservative Equity declare them the only representative benchmarks based on sound financial theory.

Licensing strategies via index providers might be the evolution of the business of asset management (equivalent to the move by IBM out of manufacturing computers into consultancy) but it does not follow that smart beta will persist.

The history of active asset management suggests that bright ideas, from the Nifty Fifty to tactical asset allocation to 130/30 funds, dim in time.

There is nothing new about 'smart beta' strategies described above. Bob Arnott and his team at Research Affiliates have been beating the drum on fundamental indexing for as long as I can remember. Some investors are adopting this approach but most are sticking to market-cap weighted indices.

Investors who are looking to take a smarter approach in managing their beta risk have many options and experts they can consult with. For example, Arun Muralidhar and his team at M Cubed offer investors their web-based AlphaEngine® software which allows any investor to research a broad range of investment strategies for any asset class:

AlphaEngine® allows clients to model their static portfolio structure, including allocations to external managers, and then make the portfolio dynamic through the inclusion of intelligent strategies. The strategies that can be tested (very quickly and easily) include:

• Rebalancing (monthly, quarterly, range based, etc.)
• More intelligent rebalancing/asset allocation strategies within rebalancing bands
• Analysis of currency hedging decisions
• Style allocation strategies within asset classes
• External manager allocation strategies for pension funds or fund-of-funds
• Relative value strategies

Clients are empowered to conduct detailed analyses of all investment decisions, through a user-friendly web interface, regardless of quantitative or programming skills. Analyses are completed in no more than a few minutes.

AlphaEngine® serves two purposes- as an extremely efficient portfolio management software, but more importantly, it allows for transparency and good governance through the implementation of a better investment process.

It allows clients to test any investment idea that they may wish to implement to manage their portfolios more effectively, across a broad range of objectives. This is done through the creation of simple investment rules. These rules can be tested at a micro level (e.g. large cap versus small cap stocks) and, more importantly as one decision in a total portfolio.

This ability to see the impact of all decisions on the total portfolio allows for better governance and risk management. The evaluation of the efficacy of rules is done using a backtesting approach, these models are then tracked to provide current recommendations, thus positioning the asset allocation to best suit current market conditions.

Download AlphaEngine® brochure Click here

Closer to home, my friend Nicolas Papageorgiou, a professor of finance at University of Montreal's HEC, has developed strategies to reduce equity volatility and started implementing them for pensions and other institutional investors.

Nicolas recently joined Brockhouse Cooper as Director, Quantitative Research, where along with Alexandre Hocquard and Sunny Ng, they consult and manage money for clients who have adopted a constant volatility framework for managing tail risk:
The authors’ research shows that the failure of strategic asset allocation as the sole risk management tool can largely be attributed to the fact that volatility is not stable over time, and historical correlations between asset classes tend to break down during periods of market stress. Conventional tail-risk hedging techniques such as the use of options, swaps, and other insurance instruments can be costly and implicitly create a drag on portfolio performance.

In response, the authors demonstrate that investors can better manage tail risk and improve risk-adjusted returns by seeking to maintain a constant level of volatility. Their approach uses futures contracts to dynamically adjust the portfolio’s exposure in response to change in the prevailing level of market volatility.
When it comes to sophisticated portfolio engineering, I trust Nicolas and his team because they're smart, know what they're talking about and have actual experience working with large institutions implementing these strategies. Investors wanting to learn more should contact him directly at or call him at (514) 932-1548.

Unfortunately, most investors are not thinking about 'smart beta' or constant volatility strategies. Instead, Reuters reports they are still chasing alpha, piling into hedge funds as performance rebounds:

Investors ploughed more money into hedge funds over the past month, data from hedge fund administrator GlobeOp shows, as hopes of a resolution to the euro zone debt crisis and a rebound in markets boosted confidence after last year's losses.

Net inflows into hedge funds, as measured by the GlobeOp Capital Movement Index, which tracks monthly net subscriptions to and redemptions from hedge funds managing around $174 billion, were 2.1 percent of total assets over the month to March 1.

While this was slightly down on last month's 2.22 percent, it is nevertheless the second-highest inflow over the past six months and above the 1.12 percent recorded last March.

Investors have been cheered by an upturn in hedge fund performance so far this year, as markets have rallied in the wake of the European Central Bank's one trillion euro cash injection to try and head off a second credit crunch.

Hedge funds lost 5.3 percent last year, according to Hedge Fund Research, as they struggled to cope with volatile markets amidst the deepening euro zone crisis. However, in the first two months of the year the average hedge fund gained 4.95 percent.

"Last year was a bad year for markets overall, but people feel a little more settled now," GlobeOp's chief executive Hans Hufschmid told Reuters.

"In the last two or three months the whole uncertainty about Europe has settled down a bit and the economic numbers in the U.S. are looking pretty positive, and people are happier to allocate to hedge funds."

Sure, in the last two months things have settled down and correlations are reverting back to historical norms, but nobody knows how long this will last. Piling into hedge funds is not the most intelligent approach to managing overall portfolio risk.

Finally, I think investors really need to go back and read my comment on OTPP's Neil Petroff on active management. I regularly go over the13-F filings of top hedge funds and mutual funds, but I also go over the filings of large and sophisticated pension funds like Ontario Teachers'.

Why? Because they invest billions with the world's best hedge funds and have access to information that most of us can only dream of. If they are taking big bets on any stock, you can be sure they did their internal due diligence and consulted with their external partners.

As such, I track their top holdings and look where they're placing the most dollars at risk. I do this for a lot of funds to gain ideas, especially when I see them significantly adding to positions as a stock tanks. That is when I place a stock on my radar and pay attention to it carefully to see if a reversal is taking shape (see my Saturday comment on scars of 2008).

It doesn't mean Ontario Teachers' is always right when taking concentrated positions on stocks. Petroff admitted to me that they are wrong as often as they're right but as long as they make more money when they're right than when they're wrong, they come out ahead. That is what active management is all about.

Below, Neal Soss, chief economist at Credit Suisse, talks with Aaron Task on Yahoo's Daily ticker discussing why he sees hope for the U.S. amid global slowdown. "In the immediate moment, the outperforming economy around the world seems to the United States," says Neal Soss, chief economist at Credit Suisse. I agree and see opportunities in cyclical sectors like coal and steel which have been hammered by exaggerated concerns of a global slowdown.

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