Stop. Rethink Everything.
Why you need to reallocate your equity now
There can be very few of the world’s investors unaffected by the COVID19 crisis, so we think now’s the ideal time to stop and ask yourself: Do I still have the optimal portfolio for now? What could I be doing differently and how much difference could it make?
Crisis-related drawdowns wiped out much of the last 5 year’s of returns for many investors. Despite a subsequent stunning rebound in the US, the COVID19 crisis drawdown pulled trailing 5-year returns for UK and Eurozone equities firmly into the red.
To provide the returns promised to end investors, investment managers now likely need to source returns in the region of 6–8%. As our long-term asset class forecast shows, the only way to reach these returns for most investors in public markets is equities.
The correct way to rebuild
What’s in the toolkit?
An equity program’s most important task is to effectively capture the equity risk premium.
This premium continues to be the most important return driver for many diversified plans, and hence, building a robust equity program across market-capitalisation indexing, enhanced indexation, factor investing (‘smart beta’) and active management (both fundamental and quantitative) is key to the overall success of an investment plan.
It is important to spend a great deal of time thinking of the core portfolio and how it might fit with any satellite active strategies.
For investors wanting to make gradual shifts to de-risk their asset allocation, indexes offer the most cost-efficient way to express those tactical views.
For investors seeking large and constant equity exposure, we believe enhanced indexing is an attractive substitute for traditional indexing. Enhanced creates low tracking error portfolios by replicating the characteristics of a benchmark, while tilting the portfolio toward desirable attributes.
Compared to Enhanced Indexing, Smart Beta provides large, concentrated factor portfolios, with a high degree of active risk, giving asset owners effective tools to target desired factor exposures directly at the macro level of the total equity program.
Multi-Factor Smart Beta strategies can be considered reasonable substitutes for active management, but can also be used symbiotically with an effective active program as a completion portfolio
Once the core of the equity program is established investors can consider how to deploy active risk across equity managers. Here it is important to understand the differences between quantitative and fundamental managers and the relative benefits of allocating to them as satellite strategies:
Quantitative managers rank stocks based on various well-known and proprietary factors. But there are other qualitative attributes of a company that are less easily systematized and put into a ranking system. Because of this, quant managers take relatively small positions in many names, and require breadth in the universe they cover.
Fundamental managers also rank stocks but their analysis can rely less on quantitative methods and more on qualitative assessments based on fundamental company and industry analysis, company visits and ‘mosaic theory’. This research by its nature is intensive (and hence relatively costly) and so can be hard to apply across a wide range of stocks.
Finding the Optimal Portfolio for Equity Strategies
Given that investors need to allocate to equities, and that there is now a wide array of well-differentiated equity offerings available, it makes sense to use a combination of the products available to realise their objectives.
Indeed, our quantitative analysis of combining Index, Enhanced, Smart Beta and Active strategies within an equity portfolio makes the case very clearly that investors should and can allocate across all these strategies.
Given the assumptions listed in the table below, we find that an optimal portfolio would have a core of 75% in Index + Enhanced and 25% in a satellite of Active + Smart Beta.
The optimal portfolio has weighted average fee of 15 bps. Constraining the fee to 10 bps implies a shift from enhanced/active into smart beta. Increasing tracking error shifts from index/enhanced into smart beta/active.
Investors needing to take more risk to gain extra returns would put more into smart beta and active from the core, and those looking to pay lower fees would have to shift some of their enhanced and active to smart beta.
Expected Excess Return (%)
Active Risk (%)
Index + Enhanced
Active + Smart Beta
The above Expected returns are estimates based on certain assumptions and analysis made by State Street Global Advisors. There is no guarantee that the estimates will be achieved.