Specifically, we shifted our equity exposure from a modest overweight to neutral across most of our services, while monitoring emerging opportunities in deep-value European equities and peripheral debt. Within equities, Japan is still our largest regional overweight, followed by select emerging countries. We remain underweight duration across most regions, which helped returns modestly as bonds, somewhat surprisingly, sold off. In response to the Greece-induced flight to safety, we have reduced our duration underweight in US and Germany.
In terms of equity styles, we’re positioned for modest economic growth and persistently low, although rising, interest rates. This calls for emphasizing relative growth as well as growth at a reasonable price for most regions, except in Europe, where we’re sourcing value exposure. As we discussed in prior reports, we continue to position the portfolios for a modest economic recovery, expecting an acceleration in wage growth and stronger US household and small-business formation.
June performance was defined by the response to the potential Greek default (Performance). After rising unabated through the second quarter, global equities gave back most of their gains in the final days of June, as the crisis escalated. Concerns rose over European stability: Greece edged closer to leaving the euro after the government pushed for a referendum on bailouts. Meanwhile, Treasury yields finished with their largest quarterly increase since December 2013, as the market anticipated the US Federal Reserve’s first interest-rate hike in nearly a decade as well as a spillover of rising euro-area interest rates.
There was relatively little differentiation among regions, as equity markets declined by between 2% and 6%. The depth of the loss was determined largely by a country’s exposure to commodities and China. Beyond Greece, sovereign bond yields haven’t spiked—even for weaker countries like Italy and Spain. This suggests that investors believe that the European Central Bank can contain the damage.
Oil declined in June but finished the second quarter significantly higher, while gold and industrial metals declined. However, downside pressure on oil started to build toward quarter-end, as inventories grew and the likelihood of a deal with Iran appeared to grow. In general, the turmoil had a modest negative impact on high yield, which declined in June but finished up for the quarter.
A year ago, we wrote about the importance of using nontraditional risk premiums to supplement traditional beta sources. We also discussed the complexity of the decision, given the underperformance of these strategies during the past decade and the implementation challenges associated with governance and leverage (July 2014 Global Market Perspective).
This month, we take a closer look at the recent performance of factor strategies, and we offer thoughts on which strategies we find most attractive given today’s investment setting. We believe that looking at risks and opportunities through the prism of risk premiums offers powerful insight into opportunities. We also use this approach to discuss and evaluate tactical investment choices.
Proliferation of Smart Beta: Embarrassment of Riches?
It’s hard to pin down a precise definition of “smart beta” strategies, but they probably account for at least $300 billion to $400 billion of the exchange traded fund (ETF) market (20%–25%, depending on the source). Another $400+ billion in institutional and mutual fund assets under management (AUM) falls into this category.
The basic logic behind these strategies has been well known for many decades, but investor interest has climbed since 2008, and AUM commitments grew sharply over the past two to three years. Norges Bank commissioned two massive studies that examined the validity of active management and laid the foundation for large-scale deployment of smart beta approaches.
As these studies were conducted, there was substantial growth in product offerings from many traditional and boutique money managers, as well as ETF and index providers. The term “smart beta” even started to enter the popular lexicon, as evidenced by the growth in the number of Google searches (Display 1).
Three Distinct Smart Beta Approaches
Given the vast material already published on smart beta strategies, we won’t rehash the many familiar arguments for deploying them. Instead, we’ll look at some of the challenges in deploying smart beta approaches and discuss some of the key considerations in managing a holistic portfolio that incorporates them.
Investors can access systemic risk premiums using three vehicles (Display 2). The first is a simple rules-based index construction that’s based on one of several index providers (such as MSCI). This approach is used as the basis for ETFs and the majority of passive strategies.
The second approach is an actively managed portfolio that seeks to maximize specific systemic exposures while minimizing unintended risks. These strategies tend to rely on risk/return models to build optimal portfolios. They’re generally sold through commingled vehicles such as mutual funds and collective investment trusts (CITs), but are also available as separately managed accounts. They can include long-only or market neutral implementations, be multi-asset, and use tactical allocation among risk premiums.
The third category of smart beta is custom designed for a particular portfolio. Most often, these are a client-specific combination of risk premium strategies explicitly designed to complement the rest of the portfolio and/or meet specific fee targets. Less often, they can be a risk-completion overlay, which dynamically modifies exposures to complement changes in a core portfolio or to facilitate strategic transitions of managers or exposures.
Ideally, the implementation choice would be determined by balancing cost, liquidity, transparency, unintended risk exposures and efficacy. However, investors often lack the tools to make a detailed evaluation of products and/or the governance structure to monitor outcomes.
For example, it would be impossible to choose between passive and active smart beta implementations without a robust risk model that captures any amplification of common risks that might be introduced by either choice. In other words, could adding smart beta actually increase investors’ overall portfolio risk by adding to some exposures they already have?
How Effective Is the Pursuit of Factors?
Performance differences in the post-2008 period clearly demonstrated the need for both tactical allocation and sensitivity to the macro setting.
Outside of the traditional equity, credit and interest-rate term premiums, investors typically consider five alternative risk premiums that can be extracted across most asset classes: value, momentum, carry, defensive/quality and selling volatility. To make things simple, we’ll focus primarily on the first three factors, which are most common. Portfolios are built by taking long positions in securities or indices with favorable characteristics (such as better value, momentum and yield) while taking short positions in those with unattractive metrics.
Implementation choices impact the effectiveness of different strategies, but our work suggests that different construction algorithms can still deliver directionally similar results. So, when we examined historical returns, we chose to look at a “typical” risk-managed implementation. This approach combines high exposure to a specific premium, but sizes positions as the inverse of their volatility; this balances risk on the long and short sides of the trade. Later in this section, we’ll examine the impact of different implementation choices.
Based on long-term historical performance, most strategies (except commodity value and fixed-income momentum) feature very attractive Sharpe ratios (Display 3). There’s a surprising similarity in Sharpe ratios when the three risk premiums are averaged across all assets. Also, the pairwise correlation among the strategies is extremely low, which highlights the benefit of combining different factors to form a single diversified portfolio. The effectiveness measures of most risk premiums have remained solidly positive since 2008, but declined substantially relative to long-term history (Display 4). As we discussed above, using risk-aware construction preserved a higher, but directionally similar, Sharpe ratio versus a more naive approach.
There are many possible explanations for the deterioration in the average effectiveness of a factor fund. One explanation could be tied to the persistence of low interest rates, low inflation expectations and high liquidity supplied by central banks. This could explain the relatively strong returns attributable to carry—driven by increased demand for income and yield.
Returns to the value factor were relatively good, due to the perception of a central bank “put” that would serve as a market backstop. Distressed valuations were quickly reversed, as investors pounced on relative-value opportunities; they assumed that bad news meant more liquidity would be on the way. This landscape could also explain the failure of momentum strategies, especially on the short side: underperformance was generally short-lived, as it drove buying by yield and value managers (Display 5).
Comparing Smart Beta Approaches: Naive, MSCI Style Index and Pure Factor
How did the current environment affect the performance of different factor implementations? Can results be improved through tactical allocation and better factor construction? We think the answer to the second question is “yes.”
We looked at three ways to capture excess returns from the MSCI World Index stock universe: “naive” implementation, MSCI style indices and “pure” factor portfolios. Each approach was built for the value and momentum premiums. The naive implementation simply takes the most attractive 20% of stocks based on value and momentum metrics. MSCI style indices use a proprietary framework to create style tilts to value and momentum.
Finally, pure factor exposures are tilted to the same exposures as the two other approaches, but use a risk model to minimize risk exposure to sectors, styles (size, for example), market betas and other characteristics. The correlation among the three different approaches to capture the same premium is fairly high, but the outcomes since 2008 have diverged (Display 6).
The reason for divergent outcomes for the value premium is sector biases. Both the MSCI Value Index and the naive portfolio are significantly overweight financials and underweight technology. These exposures currently account for more than two-thirds of the underperformance versus the pure value portfolio. Obviously, if technology underperforms while financials come back, the pure portfolio would likely underperform the rules-based construction.
Essentially, the pure portfolio sacrifices some intensity of exposure to value in order to reduce unintended systemic risks (Display 7). The choice of approach is driven primarily by investors’ tolerance for loading up on unintended exposures, which could change significantly over time. This was also the case for the rules-based momentum funds, which can be substantially underexposed to value and have very large sector and/or country biases. These biases change over time, requiring more governance and risk-management resources to avoid a buildup of common risk exposures.
The construction challenge to reduce unintended risks is similar for a non-equity smart beta portfolio: it’s more difficult to address given the relatively small number of securities. As a result, the problem usually comes down to position sizing rather than security selection. In some cases, tone solution may lie in segmenting exposures on a region-neutral basis to avoid biases.
For example, a naive currency carry approach in emerging markets would result in significant exposure to Latin America and an underweight of other regions, which would capture the bulk of the risk budget (Display 8). In this case, the solution is to build region-neutral carry portfolios that have very low net exposure to any single region.
The final step in enhancing the performance of factor portfolios comes down to tactical allocation. Given the relatively low correlation and somewhat similar risk-adjusted returns among different risk premiums, an investor could start with a risk-parity approach to overall portfolio construction, and then deviate from parity based on the attractiveness of a factor, based on the pricing of the securities that make up the factor and the stage of the business cycle.
For example, the amount of portfolio risk allocated to currency carry in emerging markets could vary depending on the size of the spread between the highest- and lowest-yielding currencies (Display 9). Being aware of factor performance under different macro regimes can help reduce the buildup of common risk exposures and reduce drawdown due to changes in the macro environment (Display 10).
Most of the observations are intuitive. For example, declining yields and rising volatility would be consistent with a flight to safety amid economic turmoil. We’d expect that strategies tied to duration (fixed-income value), defensiveness (equity profitability) or rapid adaptability to changing market leadership (equity momentum) would perform well.
In this section, we focused on the challenges in designing and implementing factor portfolios, and offered some construction and tactical-allocation approaches for improving risk-adjusted returns. We didn’t discuss the benefits, which we believe justify the significant up-front investment required. We see three major advantages of using smart beta: low cost, improved transparency and access to return sources that complement the rest of the portfolio by design.
Capitalizing on Risk Premiums in Today’s Landscape
The foundation of our approach in Multi-Asset Solutions is the ability to identify and build multi-asset risk premiums, create a strategic allocation designed to meet a specific outcome, and manage the portfolio by adding value through tactical allocation among different risk premiums.
For example, we currently see opportunities to take advantage of European distress, which continued to drive a widening of valuation spreads (Displays 11
and 12). Admittedly, spreads have been increasing since 2009, so the key investment thesis is that quantitative easing and a willingness to promote credit creation will drive investors toward value stocks, given the elevated opportunity. It makes sense that most of the value is concentrated in riskier, smaller-cap stocks while highly profitable, defensive companies (such as consumer staples) trade at a premium.
Part of our framework is to evaluate the relative attractiveness of different factors. This includes a quantitative assessment of potential upside, the evaluation of the macro environment and, finally, judgment. The first component of the evaluation—potential upside—is shown in Display 13, for non-equity factors. Two areas stand out as particularly attractive: emerging-market currency carry/value and commodity-sector carry.
The emerging-market carry consists of long positions in currencies with high short-term interest rates and short positions in those with low interest rates. Currently, this strategy is capturing a yield carry (or net interest rate) of 7% (Display 14). In other words, investors have a sizable cushion to compensate for potential depreciation of the riskier long currency basket or appreciation of the safer short currency basket. History suggests that this trade has a positive expected return, especially in the current environment with wide intercountry spreads.
Similarly, commodity carry has a positive expected return based on shorting commodities with a steep futures slope (negative roll) while taking long exposure in those with less steep slopes or in backwardation (positive roll). Today, this basket would consist of long positions in petroleum and precious metals while shorting soft commodities, grains, livestock and industrial metals (Display 15). In an actual implementation, investors would size these positions to avoid net exposures to commodity beta.
Current Strategy Recommendations
We’ve modestly reduced exposure to risk assets, while implementing some of the equity exposure using call options. This will serve to automatically reduce our risk exposure if the market declines. Likewise, we used put options to buy downside protection on oil prices.
Beyond those changes, we recommend maintaining a modestly procyclical stance, based on the assumption of a rebound in US small-business and household formation. Globally, we see relatively few deep-value opportunities, but the Greek crisis is starting to cause valuation spreads in Europe to widen; this is the region in which we have the large value exposure. The key macro variable to monitor is the continuation of credit creation, which is needed to sustain the economic recovery.