Smart Beta: The Next Generation

February 10, 2015

Some have already employed GDP as a weighting mechanism instead of market cap. But to capture economic growth, other indicators are more timely and independent, such as Markit's PMI surveys. Fig. 1 shows that Markit's Global PMI Output Index is a leading indicator of GDP. Coupled with Fig. 2, which shows a strong relationship between Markit's PMI and stock market performance, we can envision a systematic approach to global investing.

Another investment example is the ability to automatically increase fund allocation from equity to fixed income when the economy slows. Similarly, in the fixed income arena, allocations can systematically shift from treasuries to investment grade to high yield as the economy expands, in order to capture superior performance. This next generation of smart beta should be considered as more of a tactical product that can be applied across geographies, asset classes and sectors.

Preferred Liquidity Profile
Investment strategies show that post 2008, the ability to offer products that are truly liquid has become increasingly important. Investors now demand the flexibility to enter into or exit positions quickly, in any situation. Furthermore, a body of academic research4 shows that risk-adjusted performance for less liquid stocks is higher than expected – so pari passu less liquid stocks will outperform and investors will pay a premium for liquid products.

A preferred liquidity profile is a solution that invests in a strategy where the underlying instruments in a portfolio or index are liquid. If a portfolio is made up of cash bonds, for example, which have a naturally lower trading volume, the ability to create strategies that have a preferred liquidity profile then becomes critical. An opposing strategy, for those willing to assume additional risk, could involve a less liquid portfolio aiming for outperformance.

Likewise with equities, the ability to embed transaction cost analysis into investment decisions can allow managers to create valuable strategies offering return profiles with corresponding liquidity. Traditionally, smart beta has focused on a set of factors or micro-factors. However, while equally weighting a portfolio may look promising at first glance, when this results in an increased weight of a less liquid stock, it will generally result in an increased cost to trade, thus diminishing returns. As soon as the focus of a portfolio turns from traditional large cap stocks, such as the S&P 500, liquidity has a cost that must be factored into the analysis.

A Clear Future
The systematic allocation and liquidity strategies are new types of smart beta profiles - not seen before in either the equity or fixed income markets – that resonate with investors today. Scarred by the "credit crunch" and the poorly understood opaque products that unravelled, today's investment professionals are looking for opportunities that are transparent, replicable and comprehensive.

Recent moves by regulators show that they are of the same mindset. IOSCO (International Organisation of Securities Commissions) established a set of principles in July 2013 that index providers will need to comply with. It is likely that the European Commission will base forthcoming regulations for index provision on the IOSCO principles. At the heart of these different procedures is the pursuit of transparency in order to address the risk of conflicts of interest. Smart beta v 2.0 is consistent with these regulatory goals.

Just as the first raft of smart beta products responded to the post 2008 investment world, smart beta v 2.0 has the potential to respond to today's environment, enabling market participants to react swiftly to economic events. Given the continuing increase in passive management, smart beta is likely to grow, especially now that investors are starting to use it more systematically. In order for smart beta products to continue to succeed, however, they need to remain transparent, replicable and understandable. The industry is now well aligned around these goals. We should not lose sight of them.


Endnotes

  1. Foster, M., S. Krouse. "Smart beta is the overnight success that took decades to arrive." Financial News, May 26 2014.
  2. Legal & General Investment Management. "An alternative view of index fund management." (October 2013)
  3. Blitz, D. "How Smart is 'Smart Beta'?" Journal of Indexes, Vol. 16, No. 2, pp. 36-40.
  4. Multiple research including:
    http://www.cis.upenn.edu/~mkearns/finread/amihud.pdf
    http://people.stern.nyu.edu/lpederse/papers/liquidity_risk.pdf
    http://www.cfainstitute.org/learning/products/publications/rf/Pages/rf.v2013.n2.10.aspx

 

 

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