Wednesday, 29 June 2016 - 20:00
Seed Weekly - Smart Beta ? The Art of Factor Investing
The passive versus active debate has raged on and evolved over the years. More investors are embracing passive investment strategies as they realise the benefits of such strategies over the long-term, both in performance and cost. I highlighted in my previous article that there is a place for both active and passive investments in constructing portfolios.
As a multi-manager, we look for the best solutions to ensure we meet our clients’ investment objectives and this at times involves blending active and passive management products. In this article, I delve into the intelligently named Smart Beta products (also known as factor investing) which are a form of passive investments.
The name Smart Beta was coined in the 1990s, although factor investing as a strategy has been in use since the 1970s. Smart Beta is considered an intersection of active and passive management as it combines characteristics of both methods through the focus on specific factors. A factor can be thought of as any characteristic relating a group of securities that is important in explaining their returns and risk. Popular fundamental factors include Value, Momentum, Quality and Low Volatility (shown in Figure 1 below).
Figure 1: MSCI Factor indices investment growth since January 1997 (in USD)
Source: Morningstar Direct
Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market capitalization based indices. In Figure 1 above, the factors have delivered better investment growth relative to the MSCI All Country World Index (MSCI ACWI) since January 1997 to May 2016. Empirical studies show that historically, factors exhibit excess returns above the market. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. Therefore, they diverge from the traditional market indices by focusing on only the area of the market that offers an opportunity for exploitation. In the same way that an active manager filters for Value or Momentum stocks for example, Smart Beta does the same.
Table 1: Fundamental factors commonly used
Source: Seed Investments
The table above lists some commonly used fundamental factors and the areas of the market that they focus on to extract excess returns. This gives an idea to the link between Smart Beta and what active managers are doing. The good active managers however should have the additional stock picking ability and specific fundamental research to generate alpha.
Figure 2: MSCI Factor indices risk and returns characteristics since January 1997 in USD
Source: Morningstar Direct
It is important to note that these factors go in and out of favour at different times, so one cannot expect one factor to outperform all the time. The chart above shows that over the period January 1997 – May 2016, the Momentum factor has been the clear outperformer but also with the highest volatility. All the factors outperformed the MSCI ACWI, both on an absolute and risk-adjusted basis. A blend of the four factors above (equally weighted) results in fairly decent returns and more importantly, reduced volatility. Therefore, since factors move in and out of favour, there is a case for blending factors in managing risk.
At Seed, we like the idea of Smart Beta and recognise the potential benefits of such a strategy in a portfolio. The Seed Balanced Fund makes use of the Low Volatility factor as a strategy within the fund. This strategy is blended with other uncorrelated strategies to ensure that we get the diversification benefits and risk management from both passive and active investment management.
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