Today’s market is as challenging as ever for investors. Many investors I speak with are considering rethinking how they build portfolios, especially as their desired outcomes aren’t consistent with the “new normal” market environment that is characterized by low and slow growth and increased volatility.
One potential way for investors to meet their goals and outcomes is to harness specific attributes of risk and return, known as “factors,” to try to produce better risk-adjusted returns.
Smart beta is simply a rules-based approach to investing that seeks to capture specific factors—or investment characteristics—that active managers commonly seek exposure to, while preserving the benefits of traditional passive approaches, including transparency, consistency and low cost.
Numerous reasons are driving investors’ increased adoption of smart beta strategies. Some view smart beta as a form of active management that can be used to protect portfolios in down markets or help lower the overall volatility of a portfolio.1 As the chart below indicates, investors also turn to smart beta strategies for their potential to provide increased alpha, income and diversification. In short, smart beta strategies can help investors meet their desired outcomes.
Source: “Smart Beta: 2015 Survey Findings from U.S. Financial Advisors,” FTSE Russell, as of 10/2015
We believe there are five essential characteristics of smart beta strategies that investors should be aware of before investing:
The factors should be well known, with compelling theoretical backing for the existence of the return patterns.
The factors are expected to be durable and robust.
The strategy can be verified empirically.
The process for capturing the factors should be rules-based, fully transparent and consistent.
The process should be investible and scalable.
Given these characteristics, there are six main, broadly accepted factors for equity that historically have outperformed the market-cap benchmark over the long term as shown in the chart below. It’s worth noting, however, that there have been periods when certain factors underperformed the broad market while others outperformed.
Source: FactSet, as of 3/31/2016
Value: Value stocks are those that trade at a lower price than their fundamentals, such as earnings or sales, would imply. Value stocks have been shown to historically outperform the broader market indices over the long term. These results have been replicated by numerous researchers over many different sample periods and for most stock markets around the world.2 Possible explanations of excess returns include investors’ behavioral biases and the reward for taking additional risk or providing liquidity in a stressed environment.
Quality: This factor focuses on companies with low debt, stable earnings and high profitability. Benjamin Graham was one of the first to recognize the quality premium among equities back in the 1930s, and he defined it as “sustainable earnings power.” It makes sense that higher quality companies are rewarded with higher returns over the longer term because they have been shown to be better at deploying capital and generating wealth than the broader market.3
Size: Small-cap stocks have tended to outperform their large-cap peers over time.4 The outperformance of small-cap tilted indices, relative to market-cap weighted ones, can be substantial during economic expansions. We saw this trend play out during the recovery from the financial crisis. Some of the outperformance of small-caps can be attributed to the fact that fewer analysts typically cover these companies, giving them the potential to surprise the market to the upside because there is less visibility into their operations.
Low volatility: Volatility—or the standard deviation of returns—is used to quantify risk because it measures the distribution of returns. The long-term historic outperformance of low volatility strategies may appear to be at odds with more traditional financial theory, but empirical evidence suggests otherwise.5 One explanation for this outperformance is that investors overlook “boring” low volatility stocks in favor of “glamorous” ones—such as Facebook or Twitter—and, in the process, miss out on the consistent returns these stocks can offer.
Momentum: Defenders of market efficiency believe that stock prices have no memory, meaning that how a stock moves today should be independent of how it moved yesterday. The empirical evidence shows something else: stocks that have done well recently may have greater potential of doing well in the near term than the broader market.6 Obtaining more exposure to stocks that have done well could potentially result in a portfolio benefitting from the momentum premium.
Yield: As a commonly used input in valuation models, the yield factor has shown explanatory power for long-term returns. Over the long term, higher yielding stocks with higher dividends tend to perform better than stocks with lower yields.7 Part of its explanatory power is attributable to the compounding of dividend reinvestments and dividend tax regulations.
Globally, there are now hundreds of smart beta equity strategies in existence. And because “smart beta” has become a catchall for a variety of strategies, investment approaches within the category can be quite differentiated and nuanced. In upcoming blogs, I will delve further into how State Street Global Advisors approaches smart beta, and I will discuss how investors can evaluate and construct smart beta portfolios.
The MSCI World Equal Weighted Index represents an alternative weighting scheme to its market cap weighted parent index, the MSCI World Index. The index includes the same constituents as its parent (large and mid cap securities from 23 Developed Markets countries). However, at each quarterly rebalance date, all index constituents are weighted equally, effectively removing the influence of each constituent’s current price (high or low).
MSCI World High Dividend Yield Index
The MSCI World High Dividend Yield Index is based on the MSCI World Index, its parent index, and includes large and mid cap stocks across 23 Developed Markets (DM) countries. The index is designed to reflect the performance of equities in the parent index (excluding REITs) with higher dividend income and quality characteristics than average dividend yields that are both sustainable and persistent.
The MSCI World Value Weighted Index
The MSCI World Value Weighted Index is based on a traditional market cap weighted parent index, the MSCI World Index, which includes large and mid cap stocks across 23 Developed Markets (DM) countries. The MSCI World Value Weighted Index reweights each security of the parent index to emphasize stocks with lower valuation.
The MSCI World Quality Index
The MSCI World Quality Index is based on MSCI World, its parent index, which includes large and mid cap stocks across 23 Developed Market (DM) countries. The index aims to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
The MSCI World Momentum Index
The MSCI World Momentum Index is based on MSCI World, its parent index, which includes large and mid cap stocks across 23 Developed Markets (DM) countries. It is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.
The MSCI World Minimum Volatility Index
The MSCI World Minimum Volatility Index aims to reflect the performance characteristics of a minimum variance strategy applied to the MSCI large and mid cap equity universe across 23 Developed Markets countries. The index is calculated by optimizing the MSCI World Index, its parent index, for the lowest absolute risk (within a given set of constraints).
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