Smart beta on the up
Smart beta strategies have been highly favoured investment options in the recent past. A Statista survey from May 2022 of smart beta exchange traded funds (ETFs), a popular vehicle for smart beta strategies, showed that 47% of professional investors worldwide allocated between 11% and 20% of their AUM to smart beta ETFs in 2022, while a further 17% allocated more than 20%. In both cases, these amounts were greater than allocations in 2020 and 2021. However, there are indications that such appetites and preferences may be shifting.
Smart beta strategies have often been conflated with, and sought to benefit from, factor-based investing. Scott Bennett, head of quantitative investment solutions APAC, Northern Trust Asset Management, maintains a firm distinction between smart beta and factor investing. As per his definition, the former commonly consists of “passive indices that employ an alternative weighting process compared to traditional market capitalisation-weighted indices”. These will usually have the same underlying constituents as regular indices but will be weighted according to some other criterion. Factor investing, meanwhile, focuses on providing investors exposure to “well-known and documented return drivers (factor premia) such as value, quality, momentum and low volatility”. Factor-based portfolios, Bennett notes, usually will not own all securities in a particular market and use other sophisticated portfolio construction techniques to generate outperformance.
With these distinctions in mind, how is the entire thesis holding up in 2023’s new high interest rate environment?
Smart beta and the contemporary environment
The new environment in 2023 has caused all kinds of shifts in investment allocation decisions and the relative attractiveness of asset classes. As Bennett observes, “unlike previous years, the combination of escalated geopolitical tensions and a rising interest rate environment (which has not been experienced in over two decades) has led to significant ramifications to the market”.
In the recent environment, smart beta performance has garnered some very strong press from a variety of sources. According to an analysis published in the Financial Times in January 2023, factor-based data provider and consultancy Scientific Beta found that factor-based value strategies achieved returns of up to 11% versus 17%-18% losses for global cap-weighted indices in 2022, while momentum strategies delivered up to 14%, and low-investment strategies up to 15%. And while these are striking data points one has to consider the situation from the perspective of the data provider.
Factor investing overall focuses on four key factors, Bennett observes: quality, momentum and low volatility. In the context of smart beta strategies, factor investing did “exceptionally well” in 2022, he confirms.
As this suggests, however, “not all smart beta strategies have been as effective” in this volatile environment. Bennett observes greater dispersion in systematic strategies with greater sector and industry exposure. Better able to weather the year’s volatility were those strategies with “more intentional focus on risks and reduced exposure to macroeconomic headwinds”, he concludes.
Factors and fundamentals
Various factor-based approaches have confirmed the potential for outperformance recently. Value strategies have performed “particularly well” over the past 18 months, according to Bennett, who also notes Northern Trust AM’s house view that “we are at approximately two years into a typical seven year value cycle”, allowing considerably more potential upside for value-based strategies.
Aside from value strategies, Bennett also counsels “increasing exposure to higher-quality companies” against the impact of higher interest rates and slower economic growth. These conditions, he believes, put emphasis on “companies with greater quality bias”, as expressed in strong cash flows, strong profitability, and sensible capital allocation decisions, and other markers. He also maintains that low-volatility strategies “will continue to play an important role”, given that equity markets are expected to remain high over the next 12-18 months.
Significantly perhaps, CFRA Thematic Research’s bulletin from 5 April 2023 reports strong inflows in the first quarter of 2023 into “high quality” ETFs. Companies in these ETFs predominantly have high cash flows, low financial leverage, and stable earnings growth.
Meanwhile, Bennett predicts that highly valued, low quality and highly volatile companies “will struggle in the current environment”. He warns of a “drastic uptick” in US zombie companies – those unable to pay their interest payments – challenging investors now that the era of cheap money is at an end. The Russell 2000 Index now has a record number of zombie companies, he notes, and investors who do not consider quality – whether manifest in income statements or on the balance sheet – “will be highly susceptible to owning a large number of zombie companies”, he cautions. In the circumstances, and in the new market environment, such risks “emphasise the importance of quality and the need to properly pair quality with other strategies”, Bennett concludes.
Smart beta stacking up
There is one significant consideration with the whole smart beta investment case: if much of the development of smart methodology took place during the recent cheap money era, what if that era was anomalous, and investment considerations are now completely different against a background of higher interest rates and dearer money?
A key indicator for evaluating quantitative investments like smart beta, in Bennett’s view, “is the relative valuation of factors”. According to this viewpoint, markets will typically offer both expensive and relatively cheaper factor strategies. Bennett believes though, that “given the unique circumstances of today’s market”, valuations in all factors (whether value, momentum, quality, or low volatility) are either at or below their long-term average, meaning we can expect to see solid valuation upside across all factors over the next 12-18 months.
Meanwhile, actively managed ETFs have shown significant inflows in the first quarter of 2023, according to CFRA Thematic Research’s April bulletin, against an overall background of significant decline in ETF commitments compared to the same quarter in 2021 and 2022. Active ETFs achieved almost US$19.9 billion of inflows in the quarter, according to the report.
In particular, smart beta gained a lot of its appeal for apparently layering outperformance onto passive low-cost market tracking strategies. If growing market volatility suddenly means that active strategies regain a lot of their allure and potential for outperformance, smart beta could find its relative competitiveness changed. Meanwhile, research consultancy ETFGI reported on 23 March 2023 that smart beta equity ETFs saw net inflows of $2.41 billion during February, and year-to-date net inflows of $8.34 billion – lower than the $36.82 billion gathered at the same point last year. The same report cited that throughout February 2023, Smart Beta Equity ETF assets increased by 0.8% from $1.26 trillion at end January 2023, to $1.28 trillion, with a five-year CAGR of 16.0%
Given these figures, Bennett maintains that, taking into consideration other opportunities, including other publicly traded asset classes, “smart beta is presenting the most substantial opportunities over the next 12-18 months compared to opportunities at a country and sector level”.
Again, if relatively cheap pricing is a main plus for factor-based investing at present, there is the question of how this may work out over the medium and longer term, and how much of the investment case is being driven by the asset sub-class’s capabilities rather than a temporary pricing situation. Investors will need to weigh such considerations carefully in the months ahead.
Smart beta in Asia
Interest in smart beta strategies in Asia Pacific is typified by the Singapore Exchange’s acquisition of smart beta index provider Scientific Beta in April 2020, as a means to facilitating the development of the local smart beta space. The current prospects for systematic investment in Asia “are extremely high”, according to Bennett, who notes how in 2022, active managers suffered from underperformance and higher-than-expected risk.
“Consequently, many investors are seeking methods to gain exposure to equities outside of traditional active management strategies,” he says. In Asia, he adds that factor investment “has taken the limelight”, given that many Asian investors understand its advantages for managing overall risk “without fully adopting passive strategies”.
One particularly strong trend in Asian ETF uptake in 2022 was the China Connect investment route between mainland China and Hong Kong, which saw an ETF trading volume of over $1 billion in August 2022 alone. Although smart beta ETFs were not included in the initial launch of the ETF Connect scheme, senior HKEX officials have said they expect more such Hong Kong-listed exchange traded products, including smart beta ETFs, to be included in the scheme in the future.
Asia’s growing appetite for sustainability is also a driver for adoption, Bennett avers, given “the easier integration of sustainability”. He notes that one consistent theme driving demand for smart beta in Asia is “the ability to integrate factor signals with ESG and sustainability characteristics”. He reports “immense uptake and consideration towards ESG and sustainability by Asian investors, to the point that it is at a consistent level with what is seen in institutional asset owners in Europe”. Thus, going forward he envisages sustainability as a prevailing theme for investors in Asia, as elsewhere.