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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
Smart beta
Bulk beta
Diversifying
beta
Thematic
beta
Alpha
Systematic
beta
Equities
Real estate
EM overweight
Value weighted
indices
Choice of
smart beta
Sovereign
bonds
Infrastructure
Demographics
overweight
Risk weighted
indices
Classic active
management
Skill in
alternatives
Corporate
bonds
Asset classes
Equity
Term
Credit
Insurance
Illiquidity
Currency
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Tactical asset
allocation
Mandates
Inflation
ESG
Skill
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 fit 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
specific 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).
Performance
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Return
11.8%
12.0%
12.5%
11.2%
10.5%
11.6%
9.7%
US 1964-2012
Standard Sharpe
deviation
ratio
11.7%
0.56
14.0%
0.48
16.8%
0.43
14.6%
0.41
15.5%
0.34
15.4%
0.41
15.3%
0.29
Information
ratio
0.26
0.35
0.53
0.31
0.47
0.42
0.00
1 Minimum variance: To construct the minimum variance strategy we use the method
of Clarke, de Silva and Thorley (2006).
2 Maximum diversification: Portfolio optimised to maximise expected diversification
ratio, which is defined as the ratio of weighted average risk to the expected portfolio
risk. For details see Choueifaty and Coignard (2008).
3 Risk-efficient (=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 five year averages of cash flows,
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.
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 stockspecific 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 diversification, 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 specific 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.
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ur
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e
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id
Ja
dl
e
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Af
ric
La
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er
ica
US
35%
30%
25%
20%
15%
10%
5%
0%
ro
zo
ne
Eu
Region
Barclays Global Government Index
Barclays Customised Sovereign Index
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 financial markets is brief and localised, and
financial market movements have no impact on the
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
7.0
16.1
6.6
3.2
7.7
1.4
4.3
9.1
2.9
3.9
4.2
6.6
1.1
Returns in USD
Source: Bloomberg, Barclays Capital, various managers
Note: some of the results use back tested data
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Volatility
% pa
19.1
19.1
24.8
10.8
17.0
17.6
4.5
2.3
13.3
7.2
5.9
8.9
13.7
5.4
Sharpe ratio
Max drawdown
0.37
0.65
0.61
0.19
0.44
0.31
1.87
0.68
0.40
0.66
0.47
0.48
0.21
58.4
61.5
35.8
55.8
53.0
17.3
4.3
17.0
31.5
23.1
32.1
34.3
25.5
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.
1.6
2.0
11.3
2.7
Bonds
Equities
Reinsurance
Commodities
Infrastructure
Hedge funds
Real estate
Contact
For further information please contact your Towers Watson
Consultant:
Melbourne 03 9655 5222
Sydney
02 9253 3333
towerswatson.com