Deconstructing Smart Beta

February 10, 2015

Traditional approaches to asset allocation are typically static and diversified across asset classes. Arguably, they are constructed with little regard to types of underlying risks. Against this backdrop, there is an emerging trend, especially among institutional investors, towards more dynamic asset allocation that hinges on diversification across risk factors.
As most investment portfolios are still constructed on the basis of direct asset class exposure, it may not be feasible for investors to apply a factor-based framework to implement policy-level decisions. Practical solutions are needed to enable investors to incorporate risk factors in the portfolio construction process while accommodating existing investment processes.
Exactly how risk factors should be included is still a nascent and fiercely debated area of research. Here we look at the practical aspects of implementation, using stylized case studies. First, we examine how returns may be enhanced (or risk reduced) by adopting alternate beta strategies designed to capture both beta exposure from individual asset classes and systematic factors (such as value). Secondly, we assess the feasibility of using risk premia portfolios, which take long-short positions to target systematic factors.

Alternate Beta as Portfolio Building Blocks
Historically, market capitalisation index strategies were a means to capture market beta, while active managers were used to generate alpha. More recently this boundary has blurred. Investors now look at a continuum of options, from traditional market capitalisation weighted strategies at one end of the spectrum, to actively managed strategies at the other.
A significant portion of the alpha delivered by active managers may be attributed to a handful of systematic risk factors]. These risk factors can be implemented within a passive mandate known as “alternate beta” or “smart beta”. Alternate beta is increasingly imposing itself as a credible choice that avoids the inefficiencies of market capitalisation weighted indexes and the higher cost (and at times lesser performance) of active managers (Exhibit 1).
Major asset classes, including equities, fixed income and commodities have seen a surge in interest in alternate beta strategies. Alternate beta typically captures systematic risks. In equities these might include small capitalisation, value, low volatility, momentum and quality. In commodities, these could include curve, value and momentum.
The development of fixed income alternate beta strategies is in its infancy. So far it has centered on fundamental-based indexes that overweight sovereign issuers with better fiscal strength and corporate issuers with lower credit risk. This is by contrast to traditional capitalisation weighted bond indexes, which accord the highest weights to the most indebted issuers.
Most alternate beta strategies aim to achieve enhanced return, reduced risk, or both. In general, investors select their strategy according to
their investment objectives.

PracticalConsiderationsFactor_fig1
 

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