SMARTER Beta strategies seek to combine the power of active investing and the efficency of passive, with the aim of providing investors with a reliable and affordable way to outperform throughout the market cycle.
What is smart beta?
Smart beta, a form of factor investing, has rapidly become a popular alternative to both traditional active and passive management and is now firmly recognised by many investors as a third approach to investing.
Within equities, smart beta investing is based on indices whose component stocks are weighted by something other than their market capitalisation. Its aim is to systematically and efficiently harvest a single factor premium or multiple factor premia – those sources of excess returns that arise and persist in equity markets due to behavioural and structural anomalies – in order to enhance returns, lower risk, or both.
SMARTER Beta is an acrostic for the Systematic, Multifactor, Affordable, Resilient, Transparent, ESG Inside, and RIPE Factors.
Smart beta – The best of both
Smart beta aims to combine the benefits of both active and passive investing in one strategy:
Best of active
Aims to achieve above-market returns or below-market risk – or a blend of both
Best of passive
Retains the many benefits of traditional index-tracking such as simplicity, objectivity, transparency and relatively low cost
How smart beta works
Traditional index-tracking follows indices that weight companies by their size – their market capitalisation. But this exposes investors to high market risk and doesn’t allow investors to benefit from stocks mean reverting to their intrinsic value, which can help generate return.
Smart beta looks instead to construct indices that harvest a single factor premium or multiple factor premia – those sources of excess returns that arise and persist in equity markets due to behavioural (i.e. biases or irrationalities in how investors behave and react) and structural anomalies (i.e. fundamental risk drivers in financial markets).
As such, these factor premia are generally persistent and not easily arbitraged away – offering potential for a repeatable and sustainable source of long-term return.*
Drawbacks of market cap-based indices
- Indiscriminately rides the noise in share prices
- Fully exposes investors to market overheating, price bubbles and market corrections
- Cannot exploit mean reversion of stocks to add value
*Please note that returns are not guaranteed
Our RIPE factors
There are many factor premia that have been identified across markets. At Aberdeen Standard Investments, however we choose to focus on five factors that meet our stringent RIPE criteria and that are therefore best placed to target robust risk-adjusted returns over the medium to long term.
Factor premia – Sources of excess returns that arise and persist in equity markets due to behavioural and structural anomalies.
Each factor must perform effectively in a constantly changing market environment
Factors should behave as expected
Factor returns will be cyclical but demonstrate long-term persistence of excess return
Each factor should be supported by empirical academic research
RIPE factors is an acrostic for the Robust, Intuitive, Persistent, and Empirical prerequisites for inclusion as a risk premia factor.
Our RIPE Factors
The RIPE factors are Value, Quality, Momentum, Small Size, and Low Volatility:
* The small size and low volatility factors are not targeted as isolated factors.
Instead, these factors are targeted during the portfolio construction phase of the investment process.
Why multifactor matters
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, however, these 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. This correlation benefit provides the opportunity to 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.
From smart beta to SMARTER Beta
At Aberdeen Standard Investments, our approach to smart beta is referred to as SMARTER Beta – an exclusive, proprietary approach aiming to help investors generate equity return and manage risk more reliably, responsibly and cost-efficiently than ever before.
Having studied the concept of factor investing in depth for over a decade, we’ve built seven features into our exclusive SMARTER Beta strategies that we believe offer clear advantages to investors:
1. Diversified factor premia
Based on our long-term experience in using factors across the investment continuum (beta/smart beta/alpha strategies), we advocate a multifactor approach that aims to provide simultaneous positive exposures to all targeted RIPE Factors, even when applied to a single factor index. For instance, even our Low Volatility index is multifactor in approach (hence the name Low Volatility Multifactor), which means that in addition to Low Volatility we also consider, at the margin, Quality factors such as the strength of the balance sheet and Value factors like valuation. This is a key point as many competing single factor designs have factor exposures that, more often than not, are underexposed to other desirable factors e.g. Value often has a negative exposure to Momentum, or even low beta, due to negative correlations.
2. Fully integrated ESG and active voting and engagement
As a Responsible Investor, we have fully integrated ESG within our multifactor equity indices since we believe ESG helps promote competitive financial returns and positive environmental and societal impact. Our ‘ESG Inside’ methodology excludes controversial companies from the initial index universe; specifically, those companies involved in the production of controversial weapons and those companies deemed to have severe controversies based on ratings by our ESG data partner Sustainalytics1. For our ESG Multifactor index family, we also optimise these specific indices towards companies that score highly on ESG criteria which results in a tilt towards sustainable companies. In addition, for all of our funds tracking our multifactor equity indices, we vote on all portfolio company holdings and, through our dedicated Stewardship team, actively engage with company management to encourage them to embrace sustainable business practices and ESG reporting.
3. Smarter factor design
Our SMARTER Beta multifactor equity indices employ enhanced, or ‘smarter’, versions of the factors used in academia. Specifically, our smarter factors make use of multiple metrics within the factor itself to enhance diversification and utilise forward looking data (where available). For example, Value is usually defined as simply book yield in academic papers whereas we also target EBITDA/EV2, forward earnings yield, and dividend yield.
4. Optimised index construction
All of our multifactor equity indices make use of an optimiser which allows us to target desired outcomes. For example, the optimisation can target a higher dividend yield, higher ESG score, and/or lower volatility vis-à-vis the equivalent market capitalisation weighted index. The optimiser also considers both risk and return in index construction which avoids unintended risk exposures and ensures that the risk contributions are proportionate to the size of stock positions and their expected future returns (i.e. it prevents overconcentration issues).
5. Frequent rebalancing with limited turnover
Since all of our multifactor equity indices are optimised this ensures that, at each point in time, we are only trading the most significant risk-adjusted changes in factor premia exposures. This is both important and distinctive as changes in the middle of the distribution are mostly noise yet many rival approaches trade based on all changes rather than just the most pronounced risk-adjusted changes in the desirable tail end of the distribution. As such, we are able to rebalance more frequently than rival approaches (i.e. on a monthly basis rather than quarterly, semi-annually or annually) with limited turnover and minimal trading costs. This more frequent rebalancing also reduces factor decay and thereby increases our exposures to targeted factor premia.
6. Concentrated and differentiated indices
We combine our multiple enhanced RIPE Factors – Value, Quality, Momentum, Small Size, and Low Volatility – in a balanced, risk-controlled way in order to reap the benefits of diversification and increase expected return per unit of risk. Consequently, our multifactor equity indices in aggregate hold a small subset of attractively valued, high quality, outperforming, smaller sized stocks exhibiting lower volatility at the portfolio level than the equivalent market capitalisation weighted index. This small yet sufficiently diversified3 subset of stocks, each with high exposure to the targeted factors, results in both concentrated indices (with around 150 securities per index4) and differentiated indices (with a high active share5 relative to the equivalent market capitalisation weighted index) so avoids crowded/overpriced trades.
7. Proprietary indices*
Our SMARTER Beta multifactor equity indices are both proprietary and exclusive so they are only accessible through funds (segregated funds or mutual funds) managed by Aberdeen Standard Investments. In other words, the indices are bundled together with our funds so we do not charge an index licensing fee which provides a material cost benefit to investors. It also means that while the performance of our SMARTER Beta multifactor equity indices and funds are publicly available, the composition and rebalancing dates are not so the market does not know how and when our rebalances will take place. We thereby avoid our rebalance trades being front run by hedge funds and other market participants – an effect that lowers the returns.
SMARTER Beta multifactor equity index families
* The indices referenced here have not yet launched but are due to do so in Q417.
Note: it is not possible to invest directly in an index.
1 Sustainalytics is an independent, world leading provider of ESG research, ratings, and analysis.
2 EBITDA/EV is a Value metric that is independent of a company’s capital structure. Earnings Before Interest, Tax, Depreciation & Amortisation (EBITDA) is a measure of a company’s operating performance while Enterprise Value (EV) is a measure of the total value of a company. Using EBITDA normalises for differences in capital structure, taxation, and fixed asset accounting while EV also normalises for differences in a company’s capital structure.
3 Elton & Gruber (2009) suggest that the most portfolio diversification benefits (the elimination of unsystematic risk) are realised after relatively few stocks are added to a portfolio and adding additional stocks thereafter only leads to marginal risk reduction. Based on their empirical research, they concluded that the average standard deviation (a measure of volatility) of a portfolio of 1 stock was 49.2%, and that increasing the number of stocks in the portfolio to 1,000 could reduce its standard deviation to a limit of 19.2%. They also concluded that with a portfolio of 20 stocks the risk was reduced to approximately 20%. Therefore, while the first 20 stocks reduced the portfolio’s risk by 29.2%, the additional stocks between 20 and 1,000 only reduced the portfolio’s risk by about 0.8%.
4 For the Small Size Multifactor index family, this number is increased to 450 stocks in order to efficiently capture the Small Size factor.
5 Active share is a measure premium of the percentage of stock holdings in a portfolio that differs from the benchmark index.
Quantitative investing at Aberdeen Standard Investments
Aberdeen Standard Investments has over a decade of experience in quantitative investment approaches that seek to provide investors with a systematic, rules-based means to capture return, manage market risk and target their investment goals.
The Quantative Investments team at Aberdeen Standard Investments has been providing investors with access to portfolios employing factor investing for over a decade.
Today we manage more than US$80 billion* across a range of quant-based investments. These span traditional pure passive index tracking to smart beta strategies to active quantitative investing that is heavily informed by our experience as an active equity investor.
All our quant-based strategies are developed and managed by a 28-strong team, comprising economists, statisticians, actuaries and ex-traders. As part of Aberdeen Standard Investments, the team benefits from the research resources, product development capabilities and trading infrastructure of a leading global asset manager, allowing the development of strategies that are innovative, robust, proven and highly cost-efficient.
*As at 30 June 2017
Aberdeen Standard Investments Quantitative Investments team
- An experienced and stable team of 28 investment professionals with complementary skillsets, including economists, statisticians, actuaries and ex-traders
- Manages over US$80 billion* across quantitative investment strategies
- One of few quant teams to embed ESG into its investments processes
- Track record in passive investing since 2005, active systematic strategies since 2007 and smart beta strategies since 2013
SMARTER Beta at a glance
Fully systematic, rules based investing
Provides targeted exposure to multiple enhanced factor premia to drive diversification benefits and improve risk-adjusted returns
Competitively priced solutions for institutional and professional investors
Designed to be more intuitive and diversified than rival approaches to perform effectively in variety of market conditions
Uses proprietary indices that are independently calculated by a leading third party index compiler
Excludes controversial companies and tilts towards companies that score highly on environmental, social and governance (ESG) criteria
Only employs factors that are Robust, Intuitive, Persistent, and Empirical
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