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The rise of multifactor smart beta

Smart beta, a form of factor investing in which component stocks are weighted by something other than their market capitalisation, has rapidly become a popular alternative to both traditional active and passive equity management. Today, it is one of the fastest growing segments of the asset management industry and is firmly recognised by investors as a third approach to investing that combines the best features of both active and passive management. Specifically, smart beta aims to achieve above market returns or below market risk, or both, by gaining targeted exposure to ‘factor premia’ that are implemented via tracking non-market capitalisation weighted indices, thereby retaining the numerous benefits of conventional indexing such as simplicity, objectivity, transparency, and relatively low costs.

Conventional indexing

In the years since their formulation by Fama, Sharpe, Lintner, and Traynor in the 1960s, the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM) had a significant influence on the practice of investment management. The EMH states that the information relevant to the price of a stock is immediately and optimally compounded into a stock’s price. In other words, stocks trade at fair value. The CAPM says that investors adjust their securities holdings to maximise the expected return for the level of risk they are willing to bear. This process leads to the market settling into equilibrium.

If both the EMH and CAPM are true then the market portfolio is the optimal portfolio. It offers the highest expected excess return to risk ratio and all investors should hold it. Stock selection and other forms of active management cannot consistently add value (i.e. generate ‘alpha’). Risk-averse investors should hold the market portfolio together with a cash position while aggressive investors should hold it in leveraged form (through futures contracts, for example). Conventional passive management, or indexing, started simply as the embodiment of this idea: one invests in a market capitalisation weighted index as a proxy for the market while keeping costs to a minimum.

Starting in the 1980s, the EMH and the CAPM came under criticism from academic economists. Practitioners also questioned how the booms and busts they experienced were consistent with these ideas of market efficiency and equilibrium. Today, few accept that the market portfolio is an optimal portfolio. The justification for market capitalisation weighted indexing has shifted; rather than an optimal investment strategy, it is seen simply as a robust investment strategy whose returns will always equal or exceed those of the average active investor over the medium to long term.

This property arises because the sum of all the investment portfolios (both institutional and retail) must be the market portfolio. Since indexing does not involve the research and trading costs of active management, which searches for inefficiencies in securities markets and aims to outperform market capitalisation weighted indices, the average active investment strategy after costs must underperform the capitalisation weighted indexing strategy. So, unless one can identify in advance those managers who will succeed, it is inferior to market capitalisation weighted indexing.

Alternative indexing

An alternative to the EMH is the Noisy Market Hypothesis (NMH), popularised by Jeremy Siegel in 2006. It argues that stock prices fluctuate more than is justified by the variation in their fundamentals. As such, stock prices tend to mean revert around their intrinsic value. We find this to be a useful and plausible alternative description of the financial markets. It leads to important insight: if the NMH is true then market capitalisation weighted indexing is not an optimal strategy. Rather, a strategy where one periodically rebalances to an alternative set of target weights will produce better risk-adjusted excess returns.

The rebalancing captures the mean reversion of stock prices in a simple, robust fashion. For example, when a value stock performs well relative to its peers, its weight in the index increases above the target weight. When the index is next rebalanced some of the stock is sold. Conversely, when a value stock performs poorly, its weight relative to the target weight declines and, at the next rebalance, more of the stock is bought. Market capitalisation weighted indices do not rebalance and therefore cannot exploit this mean reversion – they just ride it out. Smart beta is based on this insight.

While there is a lot of confusion in the industry around the definition of ‘smart beta’, and even the term itself is not universally accepted (for instance, it is also referred to as scientific beta, advanced beta, alternative beta, alternative indexing, factor investing, amongst others), it is generally accepted that smart beta refers to indices, and the funds tracking them, that are constructed and rebalanced to an alternative set of weights for the purpose of outperforming relative to equivalent market capitalisation weighted indices with similar or reduced risk characteristics.

In fact, all smart beta indices and funds share three features in common which collectively contribute to the risk-adjusted outperformance of the equivalent market capitalisation weighted approach. Firstly, they are not reliant on market capitalisation weights; secondly, they systematically rebalance back to a set of target weights to maintain intended exposures; and, thirdly, they are sufficiently diversified in order to effectively exploit the negative cross-sectional correlations and noise inherent in financial markets.

RIPE Factors™ and the move to multifactor

Factors may be thought of as any metric that can be sorted and ranked for the purposes of investment selection. A quixotic example of this could be the sorting and ranking of companies based on the shoe size of its Chief Executive Officer (CEO). However, while such a factor can be sorted and ranked, selecting companies based on shoe size (such as choosing the top decile of shoe sizes in a universe of global company CEOs) lacks any economic theory or intuition as to why it should be a driver of superior stock market performance. We believe only certain factors, those that are Robust, Intuitive, Persistent, and Empirical (RIPE), qualify as factor premia and, within equities, these RIPE Factors™ include Value, Quality, Momentum, Small Size, and Low Volatility.

There are sound investment rationales as to why RIPE Factors™ generate superior risk-adjusted excess returns over the medium to long term vis-à-vis market capitalisation weighted index approaches. These explanations are rooted in a combination of behavioural (non risk-based) and structural (risk-based) arguments. From a behavioural perspective, a mispricing arises and persists because investors have mistaken beliefs, incomplete information, or non-rational preferences. Structurally, the mispricing arises and persists because there are limits or costs to arbitrage that prevent it from being bid away.

For example, the Value factor, as first identified by Fama & French (1992), may be explained on both behavioural and structural grounds. Stocks priced low relative to fundamental metrics of value (such as high book yield) outperform due to the behavioural tendency of investors to persistently over-react to bad news which, in turn, suggests that by being long Value one is, on average, buying stocks below their intrinsic value. A structural explanation is that the Value risk premium is simply compensation for the risk of buying financially distressed stocks.

Although there is a wealth of academic and empirical research demonstrating that Value, Quality, Momentum, Small Size, and Low Volatility each outperform over the medium to long term, it is important to realise that on an individual basis these factor premia can move sideways or underperform for significant periods of time, sometimes a year or more.

Crucially though such factor premia are lowly correlated, or even negatively correlated, with each other because they tend to outperform at different stages of market and economic cycles. For instance, Low Volatility and Quality tend to perform better during an economic slowdown whereas Value and Small Size typically outperform during an economic recovery. Momentum generally performs well when markets trend and underperforms at turning points in the market cycle. This correlation benefit provides the opportunity to meaningfully increase risk-adjusted returns at the portfolio level by blending the single factors in a multifactor approach in such a way that there is persistent positive exposure to all the RIPE Factors™ in order to reap the full benefits of factor diversification.

Moreover, a multifactor approach helps mitigate the effects of drawdowns relative to equivalent market capitalisation weighted indices. This is achieved by implementing a persistent exposure to both the Low Volatility and Quality factor premia. In isolation, both of these factors produce superior risk-adjusted excess returns over the medium to long term but they also provide downside protection when fear forces equity investors into panic selling. This makes intuitive sense since it is the volatile and financially weak stocks that sell off the most when risk aversion rises.

Given these benefits, we believe the industry is now at an inflection point and starting to move towards multifactor approaches. Indeed, the FTSE Russell 2017 smart beta survey shows that multifactor is now the most popular smart beta equity strategy with 64% of asset owners evaluating multifactor approaches, up from 37% in 2016 and 20% in 2015.

Conclusion

Interest in smart beta, and multifactor equity strategies in particular, is mounting. Investors see the advantages of conventional market capitalisation weighted indexing but are keen to obtain higher risk-adjusted excess returns and are sceptical of their ability to select active managers who can consistently outperform. Smart beta, including Aberdeen Asset Management’s proprietary and exclusive SMARTER Beta™ (Systematic, Multifactor, Affordable, Resilient, Transparent, ESG inside, RIPE Factors) multifactor equity indices and funds which incorporate design features gleaned from over a decade of factor investing experience, is thus a third approach to investing that combines the best features of both active and passive management and provides a pragmatic, cost-effective core solution to current investor needs.

David Wickham

Senior Investment Director


 

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