The Rise Of Smart Beta
Investors today are finding it harder to achieve alpha. At the same time, risk management is also front of mind. This has given rise to new strategies which can be designed to meet both needs. Rolf Agather, managing director, research and innovation indexes, Russell Investments, discusses the increased use of ‘smart beta’ to achieve investment goals with Benefits and Pensions Monitor.
Benefits and Pensions Monitor: How would you define smart beta?
Rolf Agather: I would acknowledge our definition is broader, potentially, than others. We generally define it as transparent rules-based indexes designed to produce an exposure to a particular segment of the market or strategy.
What differentiates us from a more active strategy is it is rules-based and transparent. We basically publish all the rules that we would use to maintain the index, to rebalance it, and to price it every day. When we talk about being rules-based, these are systematic strategies and what that basically means is that we develop a set of rules for rebalancing and maintaining the indexes that don’t change, regardless of what is going on in the markets. Depending on the index, we may rebalance on an annual or more frequent basis according to a pre-specified set of rules. Markets could go up. Markets could be going down. We don’t use any discretion to adjust the index.
So it is really the transparent, systematic nature of a rules-based index approach that we define as smart beta.
BPM: Is smart beta a relatively recent phenomenon?
RA: It depends on the strategy and how you define it. Equal weighting has been around for a long time. It was just never called smart beta. Now, as this area has blossomed, it just seems to fit in naturally. The fundamental index is considered one of the pioneers of the concept because it was launched nearly 10 years ago. Some people would point to that as the real beginning of this smart beta phenomenon. However, most of the other smart beta strategies have been developed within the last five years.
BPM: Who determines the rules? Do you do it on your own for certain funds or do you work with clients?
RA: It is both. Russell has a broader research capability, including our investment management division. So we get a lot of ideas from them. We also partner with other organizations. For example, we have a great relationship with Research Affiliates who developed the fundamental index and we partnered with them on our version of the fundamental methodology. We are basically an open architecture where we not only develop our own ideas within Russell, but we are also open to partnering with other organizations.
BPM: What type of rules would we see for a typical fund?
RA: It depends on what type of exposure you are trying to get or strategy you are trying to follow.
As a good example, one category is alternative weighted indexes. The idea here is that traditional indexes such as the Russell 3000, 1000, and Russell 2000 are weighted by capitalization. That is the time-tested way to represent the market. An alternatively weighted strategy would say ‘well, that is fine if you are an investor who just wants to capture the market return, but we can also alternatively weight the stocks to produce a different outcome.’ Equal weighting has been around for a long time. That is an example of an alternatively weighted strategy. It does produce a different risk and return over time. It does behave differently over different market cycles.
Fundamental weighting is another iteration of alternatively weighted where you can weight by other measures of size like sales or cash flows and, again, that produces yet another type of outcome.
More recently, we are developing what we call factor indexes. These indexes are designed to give you exposure to well-known risk factors, such as value, momentum, quality, and volatility. To design the rules, we decide what type of an exposure we want or what sort of an outcome we are looking for. That is part of the research function – to figure out what data elements to include and what sort of logic do we use to produce a basket of stocks that will produce the desired outcome.
BPM: So it is very similar to an index fund?
RA: Yes, and what is happening is we are really using the concept of an index much more broadly and for more uses than we did in the past. We are generally defining indexes as those entities that are transparent and rules-based.
BPM: But instead of having your index represent the top 100 stocks on the TSX/S&P, you would instead have a more defined family of stocks?
It is interesting because there is some debate. We would argue that even those sorts of capitalization weighted indexes were early forms of smart beta. There is a debate about whether these new indexes should be called beta because beta was originally defined as the broad market or as a portfolio’s sensitivity to the broad market. But, if you think about it, we were already giving people the ability to capture exposure to different groups of stocks by limiting an index, for example, to the top 100 of the TSX. So really the only thing that has changed is that we no longer require indexes to be cap weighted. We can say ‘take the largest 100 stocks and equal weight them or fundamental weight them.’
Dividend yield is another example. We can create an index of high yielding companies and not necessarily cap weight them. We can weight companies by their yield as a way of orienting them even more towards yield paying stocks.
It does not have to be complicated. We can do even fairly simple things, but achieve a very unique outcome for an investor.
BPM: What sort of return improvement would we see with smart beta over a typical index fund?
RA: We do try to stay away from designing or having a specific performance outcome in mind or comparing apples to oranges. That starts to get into the realm of active management.
For us, it is really trying to represent an exposure or an alternative weighting strategy and then letting the investor decide whether they believe that strategy will produce a desired result. An example I would use is when we originally created our Russell 1000 large stock index and the Russell 2000 small stock index, we were not taking a view on whether one would be better than the other. We were saying, ‘to the extent you as an investor want to invest in small stocks because you think they might do better, we’re giving you that opportunity.’ The same is true for some of our newer indexes.
For us, it is more about giving you exposure to something. I talked about these factor indexes. So if you wanted the ability to implement a momentum strategy, we have an index that you can use. You would not have to go and figure out what the high momentum stocks are and how can I put those in a basket. For us, it is more about engineering that exposure. We do not necessarily go through and say ‘okay, can we get a better return if we make this change to the methodology.’ We’re giving active investors the tools to efficiently express a certain view on the market.
BPM: Front of mind with most investors, especially pension funds and institutional investors, is risk. Can you develop risk weighted, risk rules-based smart beta funds?
RA: We have a number of indexes that can potentially lower risk in a variety of ways.
We just did a smart beta survey earlier in the year and low volatility strategies are among the most popular with institutions, in addition to fundamental weighting. Interestingly, low volatility strategies were used by 100 per cent of the Canadian respondents. There are a number of variations on low volatility strategies in the market. Russell has what we call a defensive index, which not only looks for companies that have low volatility, but are also high quality. Based on our research, we believe the combination of those two aspects really produces a much more defensive strategy than simply finding companies that have had historically low volatility.
Other low volatility strategies might say ‘let us risk weight companies so those companies that have the lowest risk would have the highest weight.’ The point is that there are different ways of constructing indexes that might actually have the same objective.
The key, again, is they will behave differently over different market cycles. Different strategies may have different industry or company concentrations, so we try to educate people, especially with low volatility, because you might find one index gives you a higher exposure to utilities or other financial stocks versus another. That is important to recognize – what different strategies are going to give you in terms of concentration.
BPM: Why the increased attention on smart beta today? Is it because alpha is so hard to find these days?
RA: It is one of them. As an index provider, my perspective is a lot of what drove innovation are ETFs. If you look at the evolution of the ETF industry, once ETFs started to become popular, they basically licensed all the well-known indexes, all the broad market indexes – S&P, Russell, MSCI – and then they had a problem. They still wanted to create new products, but all those basic indexes were taken up. What are you going to do?
And the index industry responded. We started to create these new types of indexes to meet the needs of investors. As alpha has become harder and harder to find or as alpha is increasingly being explained as systematic exposures, you have had this convergence of that fact, plus the fact that ETFs now are looking for new intellectual property and new strategies that they can use in their product creation.
BPM: Is there a typical size that these funds can initially grow to before they are closed?
RA: We have not seen that yet. As an index provider, we can create all sorts of index strategies. Those are basically managed by us as paper portfolios and we can publish the results of those. However, there may be no money tracking the index and there are more indexes out there now than there are funds. Because some of the smart beta indexes are so new, they are not at capacity.
However, one of the characteristics of a broad index is relatively high capacity. So we talk about fundamental, which has been out now for 10 years. There are lots of products on fundamental. I think they are approaching $200 billion in assets under management. Still, I have not seen any research that would suggest that the fundamental strategies are at capacity.
BPM: Are these accessible to any size pension fund?
RA: Yes, and that is also where it is important to recognize that, especially for institutional plans, they have a lot more options on how to get exposure. So it is interesting because they do not necessarily have to use an ETF or mutual fund. We actually talk to some asset owners directly, typically the larger ones, and if they have their own internal capability for managing passive funds, they could do that. We can also help the institution implement these strategies. Or they could simply go to their passive fund provider and say we are interested in this defensive index and we want that managed as a separate account. If there are enough investors, a fund provider could create a commingled fund and price that very competitively as an institutional product or create a mutual fund or an ETF. So institutions have a much broader array of vehicles that they can use.
BPM: What are some of the questions that you hear from pension funds when they are considering adopting these?
RA: When I am at conferences what I get is ‘is it active or passive’ and you have that discussion. Nobody likes the name. We have that discussion. Originally, early on, when we developed these strategies, we would talk to institutions a lot about the methodology, what rules were used, and we talked about the performance characteristics and what that looked like.
Obviously, there were trading costs and implementation costs, but now the questions are shifting to ‘how do I incorporate this into my portfolio? I know I want to have a low volatility allocation, but I have an existing portfolio. How do I do that?’ So it is more they are seeking information and education about how they might be able to incorporate that into their portfolio. That is probably the main thing.
Also, what sort of new factor exposures or concentrations does this introduce because we know that if you implement a value strategy, that potentially is going to give you a concentration to potentially other sectors or things like that. So there is definitely a need for analysis of what will it do to my portfolio if I implement a strategy.
BPM: What about fees? Are they the same as passive or somewhere in-between?
RA: I would say to the extent you have active fees and you have passive fees, they are more towards the passive side of the equation. There is more intellectual property value in smart beta indexes than traditional passive indexes, but not as much as a good active strategy. In some cases, the implementation, for us, is more difficult because we do have to rebalance more frequently. The traditional cap weighted indexes, we rebalance once a year. Some of these newer indexes, even fundamental, we will rebalance quarterly or we will have different mechanisms for resetting them. It is a little more effort on our part.
BPM: Any final thoughts?
RA: The one thing I talk about at conferences is there has been this incredible period of product development with new ideas and innovations coming to market. It stands to reason that the ETF industry is going to want us to continue to innovate. But we also have an obligation to help investors figure out how to use all the products we have already created. I try to caution people not to look for the next flavour of the month; that this is real money, people’s wealth we are talking about. The goal here is to help them improve that wealth with products that have already been created and that have lasting investment merit. Part of my sermon is to focus on the meaningful strategies we have already developed and help people understand how to use those in their portfolios.