February 2014
Schroders
Smart Beta
QEP Global Equity Team, Schroder Investment Management Australia Ltd
Executive summary
Smart beta may be the latest trend in the investment community but the concept is far from revolutionary.
Smart beta simply takes the ideas of style investing and packages these ideas into an index-like product. Its
recent popularity, however, has probably more to do with the growing awareness of the shortcomings of
traditional indices rather than a resurgence of interest in style based investing. The smart beta approach does
address some of the issues with market capitalization weighted benchmarks that Schroders has been
highlighting for many years. Some of the market capitalization benchmark issues include:
1.
Anti-Value: Market capitalization weighted indices are a buy-and-hold strategy that are akin to momentum
investing that incorporate an anti-value bias due to their inability to trade out of expensive and into cheap
stocks.
2.
Excessive concentration: The momentum bias in market capitalization weighted indices can result in
investors becoming overly concentrated in stocks, sectors, countries and/or themes that have outperformed
the market in the recent past. At the very least, this can lead to a less diversified and riskier portfolio whilst,
at the extreme, it can amplify market fads such as the bubble in the Japanese stock market in the late
1980s or the Technology bubble of 1999.
3.
Narrow or inefficient use of the universe: By arbitrarily restricting the investment universe based on
market capitalization, investors artificially narrow their opportunity set or crowd out the ability of smaller cap
stocks to contribute meaningfully to performance, thereby introducing inefficiency when attempting to
maximize returns.
Smart beta strategies only really address the first issue of market capitalization benchmarks, that is, they tend to
reduce the anti-value bias. However, the automated nature of smart beta investment strategies means that
these indices can lead to highly concentrated portfolios in one theme. Thus the ‘set and forget’ rules based
strategy can increase the risk of the investment because it ignores the changing nature of risk through the
economic cycle. Further, many of the smart beta offerings limit the investment opportunity set to those
companies currently in the main market capitalization index maintaining a bias to larger capitalization stocks
whilst ignoring more investment opportunities outside of the index. We believe that when constructing an
investment portfolio addressing all three issues leads to better outcomes for investors.
As with any investment strategy, especially rules based approaches, investors should clearly understand the
stock level impacts of what they are investing in – particularly with respect to valuation, turnover and
concentration.
Introduction
Smart beta is the latest trend in the investment community but the concept is far from revolutionary. Smart beta
simply takes the ideas of style investing and packages these ideas into an index product. In this article we will
outline what smart beta investing is and how it is constructed to address some of the issues that have been
uncovered with market capitalization benchmark investing. We then explore in more detail the benefits of using
a non-market capitalization approach and how this approach can lead to better outcomes for investors. Finally,
we highlight how smart beta strategies only partially address the market capitalization issues and discuss why
constructing an investment portfolio addressing all three issues will lead to better outcomes for investors.
What is smart beta?
Smart beta is the latest investment trend based on style investing whereby specific investment ideas are
implemented in a ‘transparent’ rules-based product that is non-market capitalization weighted. Well-known
examples of smart beta products include: RAFI Fundamental Index, MSCI Value Weighted Index, MSCI
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February 2014
Minimum Volatility and FTSE EDHEC-Risk Efficient index series. The concept of style investing is not a new
one, having been documented and incorporated into investors’ portfolios regularly since the 1970’s using
various investment ideas such as small-capitalization investing. In fact, it could be argued that style investing
goes back as far as the 1930’s when Ben Graham first discussed a value approach to investing.
What is new about smart beta then?
There are two significant differences between style investing and smart beta investing. First, smart beta
investing moves away from a market capitalization weighting scheme and uses alternative (non-market
capitalization) weighting schemes. Second, smart beta investment products are packaged using ‘transparent’
rules that determine how the product is rebalanced. This means that the smart beta product can be tracked
through exchange traded funds (ETF’s) and as such, they are often viewed as another form of passive
investing, which would be incorrect. Only the market-capitalization portfolio can be held by all investors, and all
other approaches are forms of active management that require regular re-balancing, thereby incurring
transaction costs.
Smart beta indexing also masks inherent biases and concentration into investment themes which may result
from these simple (transparent) rules. The result is that investors should closely monitor these smart beta
products to ensure the risks being taken are appropriate, and that they maintain positions to match
expectations.
Exploring the benefits of non-capitalization weighting approaches
In constructing unconstrained global equity portfolios, we advocate for a non-capitalisation weighting approach
because of the inherent problems that market capitalization weighting schemes experience, including:
Anti-value: A market capitalization weighting scheme is a buy and hold strategy that funnels investors into
expensive/momentum stocks that are assigned higher weights (due to their higher market share) while downweighting cheaper stocks. This is akin to a momentum strategy that buys high and sells low. In part, the
performance drag from holding the largest stocks that have gone up in price and has become more expensive is
the other side of the well documented small-capitalization effect. As we show in Exhibit 1, historically the largest
stocks in the index (i.e. ‘National Champions’) underperform compared to the rest of the index.
Exhibit 1: The underperformance of National Champions
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Growth of $1
9
8
7
6
5
4
3
2
1
0
1988
1991
MSCI World
1994
1997
2000
2003
Top 3 National Champions
2006
2009
2012
MSCI World Equal Weighted (EW)
Source: Global Financial Data, QEP Schroders, Gross returns in USD
Excessive concentration: Market capitalization weighted indices can lead to highly concentrated portfolios
when particular stocks, sectors, and/or countries are thought to be entering a sustained growth period resulting
in stock prices being pushed higher and valuations becoming expensive. Exhibit 2 highlights two such
episodes; first the late 1980’s when Japanese stocks comprised 44% of the MSCI world index. Second, during
the dot-com bubble of the late 1990’s where we saw technology stocks comprising approximately 36% of the
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index. Following these periods both investment themes underperformed compared to the rest of the market for
substantial periods or time, resulting in losses for investors that remained invested in these themes.
Exhibit 2: Weight of technology or Japanese stocks in the MSCI World index through time
Technology/Telecoms bubble of 1999/2000
Japan Stock Market bubble of the late 1980’s
% Weight
% Weight
50%
50%
40%
40%
30%
30%
20%
20%
10%
10%
0%
0%
1994
1997
2000
Year
2003
1986
2006
1989
1992
1995
1998
2001
Year
Source: Global Financial Data, MSCI, QEP Schroders
Concentration can also appear at the stock level. As exhibit 3 reveals, it is not unusual for the stock markets of
individual countries to be dominated by a single stock or a handful of stocks that reduces diversification and
increases the potential for volatility.
Exhibit 3: Percentage weight of largest companies by country to total country market capitalization
100%
Largest stock "National Champion"
Top 3 National Champions
% Weight
80%
60%
40%
20%
SPAIN
SWITZERLAND
ITALY
SOUTH KOREA
TAIWAN
SINGAPORE
HONG KONG
AUSTRALIA
FRANCE
GERMANY
BRAZIL
CANADA
UNITED
KINGDOM
JAPAN
UNITED STATES
0%
Source: Global Financial Data, MSCI, QEP Schroders, As at 31 December 2013
Such issues of concentration are however not solely the domain of market cap weighted indices. Smart beta or
alternative methodologies can also result in very concentrated portfolios. We show in exhibit 4 below the
concentration of a number of alternative index approaches.
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Exhibit 4: Asset allocation of alternative beta approaches
Source: Global Financial Data, MSCI, QEP Schroders, Societe Generale, As at 31 August 2013
Narrow/inefficient investment universe: By restricting the portfolio to a narrow universe based only on market
capitalization investors are unnecessarily limiting their investment opportunity set. This reduces the return
potential of the portfolio by only investing in larger stocks. Some index providers have increased coverage to
include a larger number of stocks, but still use market capitalization as their primary threshold to determine
membership of these indexes, resulting in these portfolios being weighted heavily towards the mega-large
capitalization stocks. This strategy reduces the return potential that smaller companies can offer and is an
inefficient use of the investment universe.
Exhibit 5: Distribution of size categories in two market capitalization indexes
MSCI World
MSCI World IMI
80%
80%
60%
60%
40%
40%
20%
20%
0%
0%
Mega-Cap
Weight in Index
Large-Cap
Mid-Cap
Mega-Cap
Proportion by Number
Large-Cap
Weight in Index
Mid-Cap
Small/Micro
Proportion by Number
Source: Global Financial Data, MSCI, QEP Schroders, As at 31 December 2013
Issues that ‘smart beta’ addresses
Any measurable non-capitalization weighting scheme works to remove the anti-value bias and the return drag
from mega stocks provided it involves some degree of rebalancing back to a value not determined by price
movements. This weighting mechanism can be anything that is quantifiable but the simplest form of a noncapitalization weighted index is one that applies equal weights to each stock. As such no additional information
is required for the index aside from the list of stocks and a rebalance frequency. Other examples of metrics
used to weight stocks within smart beta indices include; fundamental weighting whereby the size of a company’s
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assets or earnings are used to derive a weighting scheme; whilst minimum volatility indices are rebalanced back
to a set of stock weights that would create a low volatility portfolio. If a stock performs very well its weight will
increase, but unlike a market capitalization weighted index, the stock’s weight adjusts back to its starting weight
once the smart beta index is rebalanced (typically 2 or 4 times a year). It is this rebalancing effect that is
important rather than the actual choice of weighting scheme as it helps investors avoid chasing the most
overvalued companies.
To illustrate this point in exhibit 6 we plot the MSCI World index and two additional indices derived from it. The
first index uses the same constituents of the MSCI World index but applies equal weights to each stock (equal
weighted). The second measure adopts an arbitrary weighting scheme, in this case we weights stocks by the
length of a company’s name, that is the stocks with the longest names gets the largest weights. The choice of
weighting scheme may seem esoteric but it means that the weighting scheme doesn’t contain a performance
bias (e.g. through investing in cheaper or lower volatility stocks).
Exhibit 6: Performance enhancement from non-capitalization weighting schemes
1,000
900
MSCI World: Equal Weighted
800
MSCI World: Reweighted by Length of Company Name
Growth of $100
700
MSCI World
600
500
400
300
200
100
0
1988
1991
1994
1997
2000
2003
2006
2009
2012
Source: Global Financial Data, MSCI, QEP Schroders, As at 31 December 2013
Using these simple weighting schemes we observe that moving away from a market capitalization weighting
scheme leads to higher performance over the 25 year time-period analyzed. The only time-period where the
non-capitalization indices lagged behind the MSCI World index was during the large capitalization bubble of the
late 1990s, although this quickly reverted in the early 2000s. In other words, investors could have materially
improved their long run performance by simply reweighting the same stocks back to a non-price sensitive
starting point.
Essentially, smart beta investing is rather simple. There is no hidden alpha that these approaches have
managed to extract that has not been available to active management for decades. Whilst we support the fact
that smart beta approaches help to remove some of the large capitalization anti-value bias inherent in traditional
indices, we feel that investors should be more ambitious when looking to maximize the strategic opportunities
available to them.
The problems with ‘transparent’ rules-based approaches
Historically, style investing has been considered to be an active investment approach with manager oversight.
However, smart beta investment products are predominantly packaged using a ‘transparent’ rules-based index
approach. Such passive ‘transparent’ rules-based approaches use automated responses to the market with
minimal (or no) human oversight and can result in concentrations in the portfolio that an investor may not be
comfortable with. By marketing smart beta as an index like product investors may think that they don’t need to
apply the same due-diligence that they would to an active manager. Unfortunately this is not the case because
automated rules can lead to outcomes that the investor may not expect and build up unexpected risks in their
portfolio.
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An additional concern with automated processes and concentration is that there is no human managing the
process to help navigate the portfolio through the economic cycle. This can lead to sudden and dramatic
changes in portfolio characteristics at rebalance dates, which would be considered unacceptable in any actively
managed strategy and alter the investment themes the portfolio is exposed to.
Exhibit 7: Change in MSCI AC Momentum Index country and sector allocations
Regions/Country Allocation
Sector Allocation
80%
80%
Oct-13
Nov-13
Oct-13
60%
60%
40%
40%
Nov-13
20%
20%
0%
0%
United
States
Japan
Pacific ex
Japan
Other
Cyclicals Staples & Financials
Health
Care
Other
Sectors
Source: Global Financial Data, MSCI, QEP Schroders, As at 31 December 2013
By way of an example, exhibit 7 shows the change in allocation for the MSCI AC Momentum Index from the end
of October 2013 to November 2013 when the index is rebalanced. There is a significant shift in the investment
strategy on the rebalance day, including a rise in the weight allocated to US stocks from 37% to more than 60%,
and a subsequent down-weighting of Japanese stocks from 34% to less than 14%. In terms of sectors the
allocation to relatively defensive sectors of Health Care & Staples falls from 41% to less than 14%, while
exposure to more cyclical sectors increase from 25% to over 50% of the portfolio. Such a rapid change in
allocation has dramatically changed the portfolio characteristics and the drivers of the portfolios performance
going forward. Large shifts in allocation were also observed in RAFI Fundamental Indexes around the Global
Financial Crisis. At the height of the crisis the RAFI Fundamental index rebalanced into the financial sector
increasing the weight to financials by over 6% in one day. This trade reversed the next rebalance with the
weight to financials dropping by over 6%. The observed change in portfolio allocation also highlights the
consequence of there being no human oversight managing the process, helping navigate the portfolio through
the economic cycle. Portfolio management involves skillful portfolio construction, efficient implementation and
risk management, which delegating your investment to an automated process can not achieve.
This is particularly evident when we examine exhibit 8 which shows the annual returns of a range of alternative
“smart beta” indices relative to the MSCI World index in USD.
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Exhibit 8: Relative returns in USD vs MSCI World Index
Source: MSCI, Bloomberg, FSTE as at 31 October 2013. The indices used are MSCI World Equally Weighted Index, MSCI Minimum
Volatility Index, MSCI World High Dividend Yield Index, FTSE Developed ActiveBeta Momentum Index, FTSE RAFI Developed 1000 Index,
MSCI World Value Weighted Index, MSCI World Quality Index, Societe Generale Quality Income Index.
We can see that the dispersion in annual returns across these different strategies can be quite large and prone
to sudden reversals. In investing in these strategies it is important that investors understand the key driver of
returns and particularly the valuation of stocks in that strategy.
Another concern is that many of the smart beta investment providers restrict the investment opportunity set to
comprise only the same small subset of stocks that the main market capitalization index that they are following
utilize. Typically the main MSCI non-capitalization weighted indices start with the appropriate MSCI index as
their universe, and then re-weight these constituents following the smart beta strategy rules. Alternatively some
smart beta investment providers do expand their universe but use the universe inefficiently. This limits the
scope for potential investment returns that investors could access from broadening their investment universe
and may increase the risk of the portfolio by reducing the diversification benefits that a larger universe could
provide. Exhibit 9 highlights two smart beta products: the MSCI AC Momentum and MSCI Minimum Volatility
and compares them to the MSCI World Index. The graph shows that the weight to mid-capitalization stocks is
still very small with no more than 5% of the portfolio being held in this area of the market in the most diversified
product MSCI Minimum Volatility.
Exhibit 9: Distribution of size categories of MSCI AC Momentum and MSCI Minimum Volatility
80%
60%
40%
20%
0%
Mega-Cap
MSCI World
Large-Cap
MSCI AC Momentum
Mid-Cap
MSCI Minimum Volatility
Source: Global Financial Data, MSCI, QEP Schroders, As at 31 December 2013
Exhibit 10 highlights the increased return potential that is available when moving down the size spectrum. The
chart shows the excess returns over the market that investors could access by investing in smaller companies
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globally. As can be seen in the plot as you move down the size spectrum you find excess returns increase. By
not fully exploiting this opportunity set investors are potentially forfeiting significant investment returns.
Exhibit 10: Excess returns to a Value and Quality strategy in each size category relative to the market.
Mega-Cap
Large-Cap
Mid-Cap
Small-Cap
0%
1%
2%
3%
4%
5%
6%
7%
Annualised returns (%p.a.)
Source: Global Financial Data, MSCI, QEP Schroders, Gross returns in USD
Summary: Smart beta or not so smart?
Smart beta may be the latest trend in the investment community but as we have discussed in this article its
investment approach is far from revolutionary. Smart beta uses the ideas of style investing and packages them
in an index-like framework. This approach has some benefits that Schroders has been advocating for many
years, but only partially addresses the negative issues of market capitalization weighted benchmarks. These
negative issues include:
1. Anti-value that forces the investor into a momentum strategy which over-weights expensive stocks and
underweights cheap,
2. Concentration into sectors, countries, and/or themes that are generally expensive and risky,
3. A narrow or inefficient use of the investment universe that crowds out the contribution to returns and
diversification benefits that a broader investment opportunity set provides.
Smart beta strategies generally only addresses the first issue of market capitalization benchmarks, that is they
tend to reduce the anti-value bias. Many of the smart beta offerings limit the investment opportunity set to those
companies currently in the main market capitalization index. Of greater concern is the automated nature of
smart beta investing and the lack of human oversight, meaning these indexes can lead to highly concentrated
portfolios in one theme and have large changes in portfolio composition on the arbitrary rebalance date.
The range of Schroders QEP Global Equity strategies address all three issues of market capitalization
benchmarks when constructing an investment portfolio. They capture the advantages which ‘smart beta’
provides, but overcome its limitations by overlaying active stock selection focused on company fundamentals of
value and quality. Our highly diversified portfolios recognize that portfolio management is also about skillful
portfolio construction, efficient implementation, and risk management, which is best done by an experienced
team of investors.
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Disclaimer
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They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274,
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