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June 2022
AAM Magazine
June 2022
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Smart beta to the fore

By Goh Thean Eu   
  • Asia
  • Global
Quality and value seen to take the limelight as central banks raise interest rates

The popularity of smart beta strategies have been on the rise in recent years because they allow investors to combine the best of both active and passive strategies.

Data from independent research firm ETFGI shows there were US$1.32 trillion of assets under management in smart beta exchange-traded funds and exchange-traded products worldwide as of November 30, up from $999 billion at the beginning of 2021. Meanwhile, inflows into smart beta ETFs and ETPs grew more than three-fold to $148.28 billion in the first 11 months of 2021 from the same period of 2020. November marked the 16th consecutive month of net inflows into these products. 

There is also an increasing trend of smart beta factors with environmental, social and governance or ESG characteristics, driven by increased demand for sustainable investments.

In this question and answer with Asia Asset Management. Yvette Murphy, senior portfolio strategist at State Street Global Advisors, and Scott Bennett, head of quantitative investment solutions for Asia Pacific at Northern Trust Asset Management, share their views on smart beta investing and the evolving trends. 

What is smart beta and how is it different from factor Investing?

Yvette Murphy: The terms ‘smart beta’ and ‘factor investing’ are often used interchangeably in asset management. Factor investing has been employed by institutional investors for decades across multiple asset classes, whereas smart beta is a relatively new term used by practitioners to describe an alternative to traditional active and passive investing. 

Smart beta is an industry label for systematic, non-market capitalisation weighted investing. The approach allows investors to make active decisions by investing in well understood sources of excess return – i.e., ‘style factors’ – while leveraging the strengths of traditional indexing such as transparency and cost-efficient implementation. 

The investment rationale of smart beta and factor investing is generally similar. However, factor investing can be thought of as a broader term encompassing both smart beta – the majority of which are equity strategies – and other quantitative strategies distinguished along security valuation (more sophisticated factor definitions), portfolio construction (more dynamic, alpha-driven approaches) and asset class dimensions (equity, fixed income, currency and multi-asset class factor approaches).

Scott Bennett: While on the surface smart beta and factor investing may look the same, there are significant differences in terms of risk efficiency, implementation and portfolio outcomes. A key benefit of factor investing is the ability to combine multiple factors to deliver more stable returns. 

Smart beta commonly refers to passive indices that employ an alternative weighting process compared to traditional market capitalisation weighted indices. Typically they have the same underlying constituents as traditional indices, however the weighting of those securities is based on something other than market capitalisation, such as equal weighting, fundamental weighting or inverse volatility weighting. 

Typically, smart beta is aiming to provide less reliance on market pricing to determine company weights. Smart beta products typically follow a published index and there is no discretion applied in the implementation.

Factor investing is focused on providing investors exposure to well-known and documented return drivers (factor premia) such as value, quality, momentum and low volatility. Factor-based portfolios typically will not own all the underlying securities in the market and will also use more sophisticated portfolio construction techniques to manage risk across multiple dimensions, in order to generate outperformance. 

What are some of the trends in the smart beta space that you’ve seen in 2021? 

Murphy: [The years from] 2010-2015 saw smart beta formalised in practitioner research, while 2016-2018 saw a proliferation of smart beta indices from all the major index providers, as well as widespread launches of financial products, especially ETFs. These included single factor smart beta ETFs, as well as the popular multi-factor strategies for their diversification properties. 

Performance for many smart beta strategies was challenged over 2019-2020, which prompted further scrutiny of the portfolio construction methodology and sources of risk and return. The long-term underperformance of value is well documented and smart beta strategies, single factor or multi-factor, that targeted value were equally challenged from an outperformance perspective relative to the market capitalisation index over this time.

One of the biggest trends we observed in the smart beta space throughout 2021, however, was an awareness of the interaction between traditional style factors (e.g. value, quality low volatility, momentum and size), with ESG and climate characteristics. Many institutional investors are formulating ESG investing policies and developing a deeper understanding of their portfolios’ ESG exposures. 

In some cases, the ESG profile of a smart beta strategy can be meaningfully worse than the parent index that it is constructed from. For example, low volatility, minimum volatility and minimum variance strategies tend to score particularly worse on carbon metrics due to their large positions in typically low risk but carbon-intensive sectors such as utilities. Given these findings, investors have been searching for approaches that carefully balance their ESG objectives while preserving the original investment properties of the smart beta strategy.

Bennett: A key trend we are seeing from investors is an increased emphasis on risk, with investors wanting to ensure they understand the risks they are taking, while achieving the maximum amount of return for the risk they are comfortable taking. Over the past two years, we have seen elevated risk in the equity market, both at the total market level and also across sectors. 

The heightened level of sector volatility has resulted in sector and regional exposures having a much greater impact on returns than usual. With investors worried about inflation, monetary tightening, supply chain disruption and geopolitical tensions, we are seeing overwhelming demand from investors to build portfolios that use risk as efficiently and transparently as possible. In essence, the risk in the portfolio is coming from factors that have been proven to be more persistent sources of excess return or risk-adjusted returns, such as value, quality, momentum and low volatility. 

In addition, we continue to see sustainability as a key trend for investors, with an emphasis on aligning portfolios with net zero emission goals. Investors are looking for investment solutions that can fully integrate sustainability into portfolio positions. 

Typically, simplistic approaches to sustainability that focus on exclusions have really been tested in 2022 as the energy sector has been the strongest performing sector. Again, a key emphasis here is investors need to control for risks, like sector and/or region, that don’t consistently add value, and look to achieve their objectives by drawing from all areas of the investable universe. 

What are some of the factors that you expect to do well in 2022, and why?

Murphy: The growth factor was a standout winner from the pandemic, buoyed by a massive injection of monetary and fiscal stimulus. The ‘stay-at-home’ trade benefited the large, growth technology names, creating a ‘pull-forward’ effect of earnings during the pandemic. 

However, in 2022, we believe the quality factor will surpass growth as inflationary pressures continue and monetary policy tightens. Rising rates make the case for valuation normalisation, and the stretched valuations for growth companies will see continued headwinds for the factor. 

We expect fundamentals to take greater focus in 2022, thereby benefitting companies that score well on quality metrics such as profitability, earnings consistency and low leverage. Further, given many central banks’ recent hawkish pivot, we believe 2022 will see a more supportive environment for the value factor’s success. Despite an impressive start to the year, the value factor is still cheap, both by historical standards and relative to growth, and has traditionally performed well in periods of rising rates.

Bennett: We view the current environment as extremely constructive for factor investing. Current valuations across all the factors are close to their long-term average, which highlights that we don’t see crowded factor trades in the market. Combining this with the backdrop of monetary policy tightening and heightened market volatility, we favour factors such as value, quality and low volatility because our analysis shows that historically, these factors have fared well in similar market environments. 

We believe that in the current environment, investors will be best rewarded by employing a multi-factor approach that combines multiple return drivers to achieve more stable returns. And while we see factors performing well, we don’t advocate timing the market with factors due to cyclicality, and that the best approach to yield consistent outcomes is a thoughtful, multi-factor approach.

What is your view on the overall awareness level and interest level on smart beta/factor investing? 

Bennett: Factor investing, as a concept, is not new; however, we have seen increased interest levels more recently. The key driver of the demand is investors looking to be much more targeted and intentional in relation to the exposures and return drivers in their investment portfolios. 

The ability for investors to identify and understand their exposures has become critical as heightened volatility recently has made it difficult for traditional active products to remain ‘true to label’ when it comes to style exposures and active risk levels. 

Technology is making factor exposures more accessible and visible to investors. So today, more than ever, investors are able to quickly identify and measure their portfolio’s exposure to various factors, and what gets measured, gets managed. 

The understanding of factor exposures is growing rapidly throughout the region, with investors looking to factors, and smart beta, to complement existing passive and active management allocations. If constructed and managed well, factor investing can provide a return above traditional passive exposures with greater levels of transparency and consistency than traditional active investment strategies. 

What is the outlook of for smart beta investing in Asia? Do you see more asset owners in Asia adopting this strategy? Why? 

Bennett: The outlook for factor investing and smart beta across Asia is very strong. Specifically, those factor strategies that are able to holistically integrate sustainability, while minimising the uncompensated risks typically found in many strategies in the market. 

The key advantage of factor-based strategies is that they are able to integrate and achieve multiple objectives. Investors in Asia are looking for solutions that can not only provide strong returns but also manage risk effectively, integrate sustainability and provide high levels of capacity so they can be scaled across large portfolio allocations. 

At Northern Trust Asset Management, we’ve been partnering with some of the largest investors across Asia to solve their most complex objectives in a manner that is scalable, transparent and reduces the probability of having any unexpected outcomes.