As alternate beta strategies move away from their market capitalisation benchmarks, investors need to be aware of sector concentration or secondary factor tilts that may arise. For instance, some value-based strategies may have a momentum bias during certain periods, and low volatility strategies may inadvertently be exposed to value stocks. Investability may also be an issue.
To illustrate the importance of understanding the resulting exposure of investment portfolios, we created a stylised portfolio based on the S&P 500® that blended a 40 percent low volatility strategy with 60 percent equally spread across small-cap, value, momentum and quality strategies. With the help of Northfield risk models, we dis-aggregated the active return of the blended portfolio.
Exhibit 5 shows that, as compared to the benchmark, the blended alternate beta portfolio has more exposure to small-cap stocks, high dividend yield and lower beta. In terms of sector exposure, it has a slight tilt towards utilities and away from technology companies. In addition, it has a bias towards credit risk premium widening, meaning that the strategy would have historically performed well in an economy that was underperforming or growing below trend. These exposures might not be what investors expected at the outset, and highlight the necessity of understanding the characteristics of their investments — in particular, the factor/industry tilts their portfolios have, the return of the factors/industries over time and macroeconomic factors to which they are most exposed.
This analysis can be extended to all asset classes and performed on the overall portfolio level as it allows investors to evaluate the efficacy of their overall portfolios over time, in view of their investment objectives and constraints.
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It is important to recognise the trade-off between an investor’s willingness to assume risk and the expected portfolio return, net of rebalancing costs. Overall, according to Jaconetti et al (2010), the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually. However, as portfolio turnover increases, transaction costs can rise significantly. In general, investors may want to select alternate beta strategies that are both simplistic and transparent in their approach and require relatively low turnover.
Implementation costs are key considerations in the portfolio construction stage, and they can vary significantly from investor to investor, as they are dependent on the size of the investment in question and how the strategy is being executed. In general, beyond custody fees, managers’ fees and potential index license fees, two types of transaction costs—both direct and indirect—need to be considered. The direct costs may include commissions, duties and taxes, while the indirect costs may include bid/ask spread, market impact and the opportunity cost of trading.