In an environment where investors are rethinking their core exposures, the adoption of smart beta strategies has been a powerful investment trend, offering investors a rules-based approach to harness specific drivers of risk and return, known as “factors.” Recent SPDR® blogs have discussed the six main, broadly accepted factors for equity and explored ways investors can evaluate smart beta strategies to determine which factor(s) to use in a portfolio. In this guest post, Jennifer Bender, Ph.D., Director of Research for Global Equity Beta Solutions, discusses ways investors are implementing smart beta in portfolios.
Today’s low return but volatile market environment is prompting many investors to rethink traditional investment models and consider new ways to achieve their investment goals. No longer a niche concept, smart beta and factor investing is attracting increased interest as investors find they may no longer be able to achieve desired returns by following business as usual.
Initially, investors approached smart beta by concentrating on a single factor, determining which of the smart beta factors made the most strategic sense in a diversified investment plan. More recently, investors have started using multi-factor strategies for potential diversification benefits across factors and improved consistency in performance. Here’s a look at how smart beta is evolving and what this means for portfolio implementation.
Single factor investing
Since their introduction, the majority of smart beta products have been defined as single factor in nature. Investors have looked to individual factors, such as value or momentum, as a way to diversify or complement their traditional cap weighted index core exposure. If so desired, with a single factor strategy aimed at targeting the “value” factor, an investor could add a slight value bias to their portfolio, with granularity and transparency—without the potential for style drift commonly associated with active managers.
Single factor investing also enables investors to express a view within their portfolio based on the current state of the market cycle. For instance, investors who are worried about today’s uncertain climate may gravitate towards low volatility strategies to help reduce the volatility and drawdown risk of the portfolio.
In this case, an investor is using a single factor—low volatility—to respond to elevated levels of market risk. As the chart below shows, downside protection is a top reason investors cite for using smart beta.
Source: “Smart Beta: 2015 survey findings from U.S. financial advisors,” FTSE Russell, as of 10/2015
Based on these survey results, it is clear to see investors are drawn to smart beta to meet a defined outcome or objective. From reducing risk within the portfolio to generating income, or by seeking a higher return stream—all of which are viable concerns in our current market environment. Single factor investing is not the panacea for the markets ails, however, and challenges do exist.
The move to multi-factor investing
One challenge presented by single factor investing is that single factors are cyclical, prone to periods of underperformance based on trends in the business cycle. For instance, quality is typically associated with the late stages of the business cycle where profits are beginning to slow and corporate leverage is increasing. Focusing on firms with quality-like traits (reliable cash flows and stable balance sheets) may be compelling. Not surprisingly, in our current environment quality is the number three performing factor through the first seven months of the year, behind low volatility and dividend yield.1
Cyclicality notwithstanding, single factors can be deployed to target a specific objective. However, investors more likely than not have more than one objective. Therefore, multi-factor smart beta strategies have begun to emerge, and may be able to:
Address the client’s targeted objectives, not just a single objective
Reduce factor cyclicality, which has the potential to lead to periods of underperformance
Potentially create a better buy and hold exposure, provided the factor combination is balanced and diversified
With multi-factor, the low correlation between factors enables investors to take advantage of potential diversification benefits across factors, help improve consistency in performance and thus mitigate concerns of mistiming factors. Multi-factor combinations can take many forms, however, and with the abundance of new strategies out there, may cause confusion.
Consistent with the ideology that multi-factor smart beta strategies can be deployed to reduce single factor cyclicality and meet specific client objectives, below are a few potential combinations:
•Balanced Yield: A combination of quality and yield may be able to generate the income investors so desperately need, with the added potential for stability by targeting firms with more stable balance sheets and reliable cash flows.
•Aggressive: Through a combination of value, size and momentum an investor may be able to seek higher returns than the market. However, these returns may be at the expense of higher risk, as each of these three factors exists further out on the risk spectrum. Potential diversification benefits may arise as value and momentum have been shown to have a negative correlation to each other.
•Strategic Core: By combining quality and value, two return-based factors which also have a low correlation to each other, as well as different business cycle dependency (quality late cycle, value early cycle) with low volatility, a factor aimed at reducing the overall risk in a portfolio, an investor may be able to target multiple objectives (reduce risk, increase diversification and seek a higher return stream). A balanced combination that may be well suited for the core of a portfolio.
Multi-factor investing has opened up smart beta to a broader set of investors to create customized portfolios and either meet objective or target themes.
At State Street Global Advisors, a balanced and diversified multi-factor approach is the area where we’ve seen the most adoption within our client base in recent years.
With muted return expectations and greater volatility forecast for the next few years, we think it will be more challenging for investors to achieve their investment objectives. This could drive increased adoption of factor-based investment approaches as investors seek to build efficient portfolios that target incremental returns and enhance diversification in a cost-efficient manner.
A market index in which individual companies are weighted such that larger companies carry a larger percentage weighting. A company’s capitalization is calculated by multiplying the company’s share price by the number of its outstanding shares. The weighting of an individual company is arrived at by dividing the value of that company by the total value of all companies in that index.
The historical tendency of two investments to move together. Investors often combine investments with low correlations to diversify portfolios.
The tendency for a security to maintain a certain direction of price trajectory. This tendency is well documented in academic research, which has made “momentum” one of the six smart beta factors that are systematically being isolated in new-generation strategic indexes.
One of the six widely recognized, research-based smart beta factors that refers to “quality” stocks exhibiting consistent profitability, stability of earnings, low financial leverage and other measures of long-term reliability such as credible and ethical corporate governance.
A smart beta factor based on the tendency of small-cap stocks to outperform their large-cap peers over long time periods.
In style investing, a strategy that focuses on companies that may be priced below intrinsic value.
The income produced by an investment, typically calculated as the interest received annually divided by the investment’s price.
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