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Understanding Smart Beta

July 2013
For several years Towers Watson has been investigating the use of smart beta
investing across a range of traditional and alternative asset classes. We are
now at a stage where smart beta has moved beyond theory and there are
several funds available today across several asset classes.
For something smart, we believe it is really quite simple. Smart beta gives the
investor the opportunity to capture a:
wider spread of risk premia than conventional systematic strategies, or
risk premium previously only available through expensive active strategies in
a cheaper way.
Smart beta strategies may have one or more of the following features:
captures existing (or alternative) risk premia (some of which might have
been hidden in active management)
improves portfolio diversity
captures long-term investment themes that some other investors are not
well placed to exploit
improves implementation versus market capitalisation.
In our view, smart beta strategies should be simple, low cost, transparent and
systematic.
To believe in the smart beta proposition, one must frst accept that there is a
wider framework than the narrow defnitions of alpha and beta which classic
fnance theory puts forward. In this framework, somewhere between alpha and
beta, lies smart beta.
Smart beta is simply about trying to identify
good investment ideas that can be
structured better, whether that is improving
existing beta opportunities or creating
exposures or themes that are implementable
in a low cost, systematic way.
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This framework hinges on building an investment
strategy as a combination of certain return drivers.
We can use the term beta for most of these return
drivers. The economic rationale behind these return
drivers can either be temporal, with a fnite term, or
secular and largely timeless. A visualisation of this
framework is provided in Figure 01.
Why smart beta?
Within traditional markets, interest has arisen partly
due to some increasingly undesirable characteristics
of market capitalisation weighted index strategies
and, in some cases, due to a loss of confdence
by some investors in their ability to extract alpha
in a cost and tax effective way. Furthermore,
several smart beta strategies in traditional markets
have recently delivered strong performance over
conventional market capitalisation weighted
strategies.
Within alternatives, interest has arisen partly from
a realisation that some of the things that hedge
funds do at great expense can be reproduced with
simple, easily accessible strategies at a lower cost.
Consequently, access to alternative betas with
fundamentally different return drivers to traditional
asset classes can potentially be achieved without
hedge fund like fees.
We take a holistic approach in considering which
smart beta approach(es) would be appropriate for
each client; for example, how an existing portfolio is
constructed, its overall objectives, risk constraints
and beliefs. In other words, we do not adopt a one
size fts all approach in recommending smart beta
strategies.
The rise of smart beta
We believe we are still at the pioneer stage in the
evolution of smart beta; however, we have now
observed several large and prominent investors
incorporate smart beta strategies into their portfolios.
Growing popularity and increasing allocations
into smart beta strategies may remain powerful
tailwinds in the foreseeable future; however, as these
strategies attract increasing amounts of capital, they
may start to refect diminishing returns over time.
In the following sections of this paper we look at how
smart beta can be harvested across the traditional
asset classes of fxed income and equities. We then
go on to examine which smart beta strategies can
be implemented across various alternative asset
classes.
Equity Term Credit Insurance Illiquidity Currency Infation ESG Skill
Asset classes Mandates
Real estate EM overweight
Value weighted
indices
Infrastructure
Demographics
overweight
Risk weighted
indices
Choice of
smart beta
Classic active
management
Skill in
alternatives
Tactical asset
allocation
Equities
Sovereign
bonds
Corporate
bonds
Diversifying
beta
Thematic
beta
Systematic
beta
Smart beta
Bulk beta Alpha
Examples of return drivers
Figure 01. The alpha/beta continuum and example approaches
Smart Beta July 2013 | 3
Equity smart beta
There have been a considerable number of academic
papers covering the ineffciencies of equity market
capitalisation weighted benchmarks and the
existence of systematic factors (value, small cap)
which can potentially be exploited by investors. Given
many of these papers have been widely distributed,
or used for investment management marketing
pitches, we do not intend to cover them in this paper.
Instead we will look at how Towers Watson sees the
equity smart beta universe and the implementation
options available within this framework.
Broadly, we split the equity smart beta universe into
two high level categories: thematic and systematic.
The systematic categories can then be split into four
specifc defnitions: equal weighted, economically
weighted, risk weighted and factor tilts.
Below we outline each of these approaches.
Thematic approaches
Thematic smart beta aims to take advantage of
secular or temporal mispricing issues (for example,
emerging wealth exposure, demographic impacts).
The underlying thesis is essentially that many
investors are excessively focused on the short
term and, therefore, mispricing exists in respect of
opportunities that are longer term in nature.
In general, our preference is for simple, transparent
strategies with a strong and intuitive economic or
investment rationale. While there are currently a
limited number of investible equity thematic options
that ft this criteria, Towers Watson continues to work
with a number of investment managers on potential
solutions/products in this space.
We note that because these strategies require beliefs
to be held about what the future has in store, the
appropriateness of such strategies is particularly
specifc to an investors existing portfolio, beliefs and
preferences.
Systematic approaches
Opportunities for systematic smart beta approaches
arise from a range of factors; for example, investor
heterogeneity and systematic mispricing (such as the
value weighted index), and some structural issues
associated with market capitalisation approaches (for
example, constituent change dates, arbitrary rules for
inclusion or exclusion).
We outline the four key systematic approaches below:
Equally weighted approach
This is the most simplistic approach to removing
the link between prices and stock weights. No
assumptions are used, or needed, for stock returns,
volatility or correlations. Implicit in this approach
is that stock returns, volatility and correlations are
unknown (or are at least expected to be the same on
an ex-ante basis).
Although simple, equally weighted approaches have
historically been hard to beat both within and across
markets, at least before transaction costs. Certainly
they have outperformed market capitalisation
approaches.
The approach in its purest sense is, however, not
practical, particularly for broad market portfolios.
The approach gives a large allocation to small and
illiquid stocks. This means that a portfolio cannot be
implemented with any signifcant size, so the strategy
has low capacity.
Economically weighted approach
This smart beta approach weights stocks by
fundamental business metrics such as sales,
earnings, book value and so on, rather than market
capitalisation. The main aim of this approach is to
remove the link between the price and the weighting
of stocks in a portfolio, and replace it with weightings
based on economic size.
Relative to a market capitalisation portfolio,
economically weighted portfolios tend to have a
value tilt, although this varies over time. However,
relative to typical value oriented indices, economically
weighted strategies include all stocks in a given
universe, rather than just the value half.
There are a number of ways of combining different
economic measures to form an economically
weighted strategy. In most cases, several measures
are used, and the weighting from each is averaged.
The underlying philosophies of the various
approaches do differ, and this can lead to some
differences in the construction of the indices.
However, we believe the effects they capture are
broadly similar.
4 | towerswatson.com
1 Minimum variance: To construct the minimum variance strategy we use the method
of Clarke, de Silva and Thorley (2006).
2 Maximum diversifcation: Portfolio optimised to maximise expected diversifcation
ratio, which is defned as the ratio of weighted average risk to the expected portfolio
risk. For details see Choueifaty and Coignard (2008).
3 Risk-effcient (=2): Mean-variance optimised portfolio assuming that expected
excess returns are proportional to the stocks downside semi-deviation, and with
stringent constraint to limit portfolio concentration. For details see Amenc et al
(2010).
4 Risk cluster equal weight: Applying statistical methods to identify major market
risk factors, assumed to be driven by industries and geographies, and then equally
weight these uncorrelated risk clusters.
5 Diversity weighting: Weighted based on the market capitalisation weight raised to
the power of a constant that is between zero and one to tilt the portfolio towards
small cap stocks while limiting tracking error. We used the value of 0.76 in our
simulation.
6 Fundamentals weighted: Weighted based on the fve year averages of cash fows,
dividends, sales and the most recent book value of equity. We introduce a two year
delay to avoid forward-looking bias. Following the original method, we select top
stocks with the largest fundamental weight. For details see Arnott, Hsu and Moore
(2005).
7 Cap-weighted: Weighted based on market capitalisation. The market capitalisation
is computed using December values at the close of the year prior to index
construction.
Strategy
US 1964-2012
Return
Standard
deviation
Sharpe
ratio
Information
ratio
Minimum variance
1
11.8% 11.7% 0.56 0.26
Maximum diversifcation
2
12.0% 14.0% 0.48 0.35
Risk-effcient (=2)
3
12.5% 16.8% 0.43 0.53
Risk cluster equal weight
4
11.2% 14.6% 0.41 0.31
Diversity weighting
5
10.5% 15.5% 0.34 0.47
Fundamentals weighted
6
11.6% 15.4% 0.41 0.42
US cap weighted
7
9.7% 15.3% 0.29 0.00
Source: Realindex, Research Affliates
Risk weighted approaches
These approaches aim to improve portfolio effciency
(return per unit risk) by making assumptions about
future volatility, return and/or correlations, generally
based on historical observations.
There are three main risk-weighted approaches:
1. Nave volatility-based weighting The weight of
the stock in the portfolio is related to the inverse of
its variance. No assumption is made about return
or correlation and, in a similar manner to equal
weighting, the implication is these are unknown.
2. Diversifcation strategies These strategies
assume that correlation is mispriced and that by
constructing a portfolio to have low correlations (a
high level of diversifcation), superior risk-adjusted
returns can be generated.
3. Volatility minimisation strategies These strategies
combine volatility and correlation through an
optimisation framework to produce a portfolio
with the lowest volatility or beta, depending on the
strategy.
We believe there are issues with many of the
strategies in this space, particularly around the
implementation of portfolio optimisation that cause
us to question the indices available. Consequently, we
believe the best way to capture the volatility effect is
through a manager that has carefully considered the
implementation issues inherent in these strategies.
Factor tilts
These approaches aim to tilt portfolios toward
attributes that have been shown in academic
literature to add value over time. Typically these are
factors that are associated with active management
styles.
There continues to be debate as to whether these
phenomena are behavioural, compensation for
additional risk, or both.
Three academically recognised factors are:
1. Value Cheap stocks (where the current market
price is perceived to be less than the market
average as measured by metrics such as Price/
Earnings and Price/Book) outperform expensive
stocks (those where the market price exceeds the
market average) as the market reajdusts towards
fundamental valuations.
2. Momentum Stocks that have performed well
recently, say over the last 12 months, continue to
perform well (and vice-versa).
3. Size Stocks of smaller companies have higher
returns.
It is possible to analyse portfolio performance and
attribute returns to sub-groups of stocks with these
features. More recently there has been interest in
managing these factor exposures separately (and
more cheaply), in part a recognition that some active
returns can be explained by these factor tilts.
Performance
Figure 02. shows the return, standard deviation
and risk-adjusted returns for a number of well-
known equity smart beta strategies using US returns
between 1964-2012.
Figure 02. Popular smart beta strategies
Smart Beta July 2013 | 5
Implementation
The availability of investible strategies has improved
and is likely to continue to improve as the concept
garners greater interest from the investment
management community. Pooled strategies exist
for a select number of strategies and where there
has been client interest, managers have shown a
willingness to add appropriate investment vehicles.
In general we prefer smart beta strategies to be
implemented over a broad universe. Breadth and
depth are instrumental to the successful application
of approaches that are systematic in nature,
such as smart beta. We do not think a narrow or
too concentrated opportunity set is suitable for
the use of some smart betas. This might lead to
unintended risks, such as over-concentration in
certain industries/sectors/countries and/or for stock-
specifc risk becoming too dominant in the portfolio
(a similar argument, however, can be made on
market capitalisation approaches in narrow markets).
Furthermore, a narrow opportunity set might lead a
systematic approach to necessarily force a solution
to maintain some diversifcation, due to a lack of
alternatives.
There is, however, no hard and fast rule as to which
market offers a wide enough opportunity set. Our
preferred option is for a developed plus emerging
markets universe as it provides the greatest breadth
and depth. Developed market only, emerging market
only or US market only mandates are also likely to be
wide enough to allow for a good application of smart
beta approaches. However, in concentrated/skewed
markets such as single countries or sub-asset classes
(for example, Australian equities or frontier markets),
using systematic approaches without considering
the markets specifc idiosyncrasies might not be
ideal. Similarly illiquidity or high custody costs in
some markets create issues in implementing some
strategies. In these cases, potential investments
should be considered on a case by case basis, taking
into account the characteristics of the market and the
investors underlying objectives.
The assumption for replacing an active allocation
is that smart beta captures some of the alpha that
active managers can deliver, but at lower costs. Two
other advantages of smart beta as an alternative to
active management are:
1. Capacity is higher than for most actively managed
strategies (lower turnover and less concentrated).
2. Higher levels of portfolio redundancy in traditional
active multi-manager confgurations can lead to a
convergence towards capitalisation weights with
some residual style tilts that can be easily and cost
effectively replicated using smart beta strategies.
Smart beta strategies are generally not
constructed as relative return products, and
typically have high tracking error relative to
a market capitalisation portfolio. This means
that the strategies will perform very differently to
market capitalisation weighted portfolios and can
underperform market capitalisation substantially,
potentially over a long period of time typically
during strong market rallies and bubbles. However,
there are also more aggressive smart beta strategies
that may underperform signifcantly in bear markets
or sharp drawdowns. There is a chance of regret risk
and consequent withdrawals from a strategy at the
wrong time. Investors should therefore have a long-
term approach to the investment we would suggest
a timeframe of at least fve to ten years.
How should smart beta approaches be
benchmarked? It is important for investors to
determine, in advance, their objectives from an
investment in equity smart beta strategies. Different
approaches to measurement may determine whether
such an investment is considered a success or a
failure. We believe monitoring versus a benchmark
should be focused on the long term.
For some smart beta approaches, the strategic
rationale may be to reduce the overall equity beta
exposure of the portfolio (that is, de-risking). In
this case, we are supportive of the strategy being
measured against a market capitalisation index
over the long term on an absolute risk-adjusted
(Sharpe ratio) basis. We would also support
benchmarking against a suitable combination of a
market capitalisation index and cash (which would
be another way of lowering the beta of the equity
portfolio) over the medium term. In cases where
a manager is managing their approach against
a specifc index (for example, an MSCI minimum
volatility index) comparing to said index is also
appropriate.
6 | towerswatson.com
Smart beta within fxed interest
Screened fxed interest
Traditional fxed interest indices, which weight
issuances according to outstanding debt, have a
fundamental faw in our opinion the most indebted
issuers constitute the greatest portion of the index.
Government bond benchmarks, in particular, have
high risk concentrations in the US and Japan. The
Barclays Capital Global Treasury Index, for example,
had a 54% weight to these two countries at the time
of writing.
Similar to many equity smart beta strategies, we
believe that any approach which breaks this reliance
on issuer size in a sensible manner represents a
signifcant improvement compared to the traditional
indices.
Towers Watson has worked extensively with global
funds management providers to explore solutions for
clients that reduce these concentration risks.
An example of this style of approach (for global
sovereign debt) is to establish two simple caps on
exposures which signifcantly alter the characteristics
of the index such as a cap on individual countries,
and a collective cap on Eurozone countries.
In the current environment of record-low sovereign
bond yields globally, this style of smart beta strategy
allows investors to maintain global sovereign bond
exposure without assuming the same level of
exposure to the US, Japan and heavily indebted
Eurozone countries.
Other alternative methods of weighting fxed interest
securities in the government bond space could be to
weight according to issuer GDP or fscal sustainability
(based on economic fundamentals). These methods
do, however, have associated concentration issues
which would also need to be managed.
While this outlines some smart beta approaches in
fxed interest, we would be generally supportive of any
strategy which breaks the reliance upon debt levels
and re-weights securities in traditional indices in a
systematic and sensible manner.
Figure 03. Barclays Global Treasury Customised versus
Market Cap (as at March 2013)
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30%
25%
20%
15%
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Barclays Customised Sovereign Index
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Smart Beta July 2013 | 7
Alternative asset classes
We believe there are a number of natural extensions
of the theory and philosophy around smart beta
which are worthwhile pursuing in asset classes that
have historically been expensive, diffcult to access
and/or illiquid in nature.
Smart beta thinking can provide many of these
desired exposures in a simple, low cost, transparent
and systematic manner, or provide easier access to
diversifying exposures which were previously diffcult
to access.
Enhanced commodity futures
Commodities provide diversifcation across the
business cycle, with prices being highest at the end
of the cycle when capacity is lowest, whereas equity
returns tend to peak earlier in the cycle. Additionally,
commodities provide reasonably strong infation-
linkages, being part of the consumer basket in most
cases.
While this type of exposure is desirable from
a strategic perspective, passive investment in
commodities has a number of vulnerabilities. We
believe that many of these weaknesses can be
improved by systematic tweaks to the investment
process.
For example, the common commodity futures indices
(such as S&P GSCI) are based solely upon the front
future contract, which doesnt seem to fully represent
the entire commodity sector anymore and is open to
being front-run by active investors.
Investing in longer dated contracts or implementing
continuous/daily rolling should theoretically avoid the
crowding of passive investors in the shorter dated
future contracts, and should also make better use of
market liquidity.
Core listed property and infrastructure
Core property and infrastructure investments usually
involve the purchase of unlisted, illiquid assets which
provide the following desirable characteristics:
long duration assets
strong cash fows that are often regulated,
contracted or otherwise protected
infation linkages
low correlation with traditional equity markets.
Due to the illiquid nature of unlisted assets,
investors often attempt to obtain exposure to these
characteristics through listed vehicles. Historically,
these vehicles have had an unacceptably high
correlation to listed equities, often to the extent
that the desirable characteristics outlined above
are compromised. Another problem with investment
in listed infrastructure markets specifcally is the
typically high exposure to energy generation assets
(which have relatively high volatility of earnings).
We believe an investment strategy which specifcally
targets stable, core, developed assets with
predictable earnings throughout the economic cycle
and relatively low levels of gearing, mitigates many of
these issues while providing access to the desirable
characteristics of infrastructure and property assets.
We further note that investments in this style of listed
vehicle typically have lower correlation with equity
markets than their traditional counterparts, given
their lower exposure to assets with high leverage and
development risk.
Foreign currency carry
Currency carry strategies invest in high yielding
currencies using capital from low yielding currencies.
The attraction of this strategy is that the real interest
rate differential rewards the willing investor over time.
The main risk involved in these strategies is that
large, adverse movements in exchange rates have
the potential to swamp the carry return over the short
term. We note, however, that this can also work in
favour of the FX carry investor, and often does, as
real exchange rate appreciation tends to follow for
countries with rising interest rates.
One way to mitigate the risks of adverse exchange
rate movements is to diversify across countries. For
example, with 10 liquid developed market currencies,
there are 45 currency pairs an investor could
potentially take positions in.
A simple smart beta approach would weight each
of these pairs equally, with the higher interest rate
currency being bought against the currency with
lower interest rates using forward contracts. The
rationale for such an approach is that higher interest
rate currencies tend to outperform lower interest rate
currencies over the long term.
8 | towerswatson.com
Emerging market currencies
Emerging market currency strategies invest in cash
and short-dated bonds denominated in emerging
market currencies. This provides the investor with an
unhedged exposure to emerging market currencies.
We believe that, in general, emerging market
currencies will outperform developed market
currencies over the longer term and offer protection
against low growth in the developed world.
We expect emerging market cash to outperform
developed market cash for three key reasons:
1. Higher productivity growth in emerging markets
should lead to currency appreciation over the long
term.
2. Many emerging market central banks have
historically suppressed the value of their countries
exchange rates, however trade imbalances are now
stressing this process.
3. There is a heightened risk of devaluation or non-
return of assets in emerging market countries,
for which a premium typically has to be offered to
investors.
We recommend that a semi-passive approach be
taken to this asset class, with a largely buy-and-
hold approach taken to emerging market currencies
subject to the managers view on country-specifc
risks and which countries might relax their currency
suppression sooner.
Reinsurance
The insurance risk premium compensates investors
for very different risks than the equity or credit risk
premia. Traditionally, the impact of natural disasters
on fnancial markets is brief and localised, and
fnancial market movements have no impact on the
frequency or severity of natural disasters, resulting in
very low levels of correlation.
There are two key ways in which investors without
the substantial scale required to obtain the exposure
directly can access this type of investment, namely:
1. insurance companies equity
2. catastrophe bonds.
While the frst option above is the easiest way to
gain access to the reinsurance market, we believe
the additional correlation with the equity market this
introduces would compromise a key reason for this
investment. Additionally, we note that the majority
of investors would have exposure to reinsurance
companies through their existing equity portfolios.
Catastrophe bonds, which usually have a term of
three years, have the same pay-off as a traditional
bond, except in the event of the insured risk
occurring, when some or the entire principal is
used to cover the reinsurance claim. This style
of investment gives direct access to a number of
different catastrophe-related risks.
The obvious risk to reinsurance investment is the
(relatively low) probability of substantial losses due to
catastrophic events. We believe that these risks can
be largely mitigated through adequate diversifcation
across regions and risk perils.
It is important to adopt a reasonable time horizon for
reinsurance investments. Like any type of insurance,
a premium is collected to reward the insurer over the
longer term for protecting the insured against certain
events. Therefore, although a loss will assuredly be
incurred at some point, over the longer term (three to
fve years) a reinsurer with a well-diversifed portfolio
is expected to have made a proft in aggregate.
Figure 04. Risk and return characteristics of a range of smart beta strategies from February 2002 to December 2012
Return in excess of
cash % pa
Volatility
% pa
Sharpe ratio Max drawdown
Equities AW: fundamental indexation 7.0 19.1 0.37
Equities EM: fundamental indexation 0.65
Listed infrastructure 6.6 0.61
Index: MSCI All World 3.2 0.19
Commodities 0.44
Volatility premium 1.4 4.5 0.31 17.3
Reinsurance 4.3 2.3 4.3
Momentum 0.68 17.0
Secured loans 2.9 7.2 0.40
ABS 3.9 5.9 0.66 23.1
FX carry 4.2 8.9 0.47
EM currencies 6.6 0.48
Index: HFRI 1.1 5.4 0.21
Returns in USD
Source: Bloomberg, Barclays Capital, various managers
Note: some of the results use back tested data
7.7
16.1
19.1
24.8
10.8
17.0
17.6
13.3
13.7
9.1
1.87
58.4
61.5
35.8
55.8
53.0
31.5
32.1
34.3
25.5
Smart Beta July 2013 | 9
Conclusion
In this paper, we have provided an overview on the
smart beta investment thesis and some of the more
common and implementable strategies. We continue
to observe an increase in both the number of
institutional clients allocating to smart beta strategies
as well as the diversity of smart beta strategies
available.
Towers Watson is deeply entrenched in the smart
beta movement and globally our clients added 65
new smart beta mandates to their portfolios in 2012.
Our vast experience and broad understanding of the
smart beta universe is demonstrated in Figure 05.,
which shows Towers Watson clients already have
$20 billion of assets invested in smart beta
strategies.
The intention of this paper is to stimulate thinking on
where and whether smart beta strategies could be
appropriate for your portfolio.
If you wish to discuss any of the approaches to
implementing smart beta in more detail, please
contact your Towers Watson consultant.
Figure 05. Total smart beta exposure for
Towers Watson clients in 2012 ($US bn)
Bonds
Commodities
Real estate
Equities
Infrastructure
Reinsurance
Hedge funds
11.3
2.0
2.7
1.6
1.7
0.3 0.3
towerswatson.com
Copyright 2013 Towers Watson. All rights reserved.
The information in this publication is general information only and does not
take into account your particular objectives, fnancial circumstances or needs.
It is not personal advice. You should consider obtaining professional advice
about your particular circumstances before making any fnancial or investment
decisions based on the information contained in this document.
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