How to Allocate to Smart Beta Within a Multi-Manager Equity Program

ADHI Ric, what are some of the key takeaways for institutional investors from your recent paper, “What Free Lunch? The Costs of Overdiversification?”

RIC Our research looked at pension funds in the U.S. (largest 100 in the U.S. and how diversified they were in their equity holdings).

  1. Most pension funds in the U.S. allocate to at least 12 and some of the larger pension plans allocate to over 30 active equity managers. So our goal was to determine how much is too much? In aggregate, the sum of the holdings of all active managers will equal the market so if you hire enough of them, you will eventually converge towards the index.
  2. A number of the largest pension funds invest inefficiently, hiring too many active managers and that diversifying capital among numerous active managers — even if those managers all have high active risk in isolation — can lead to an expensive index exposure.
  3. Once you are over 7 active managers, factors are mostly going to drive your returns. This is because stock specific risk falls very quickly as you add active equity managers. The problem is that large investors have to hire a lot of active managers due to capacity constraints. This means that all large investors are factors investors. There are those who know they are and, there are those that don’t. We encourage investors to acknowledge this reality and organizing their investment staff to focus on factor and asset class selection, which will be the key drivers of returns for large investors.

All large investors are factors investors. There are those who know they are and there are those that don’t.

ADHI What are your views on Smart Beta in the context of this research?

RIC We believe Smart Beta can play an important role, particularly for large investors. We believe investors should be conscious of their factor allocations, rather than have that reality be an unintended byproduct of your active manager program. Investors should know what factors they want to expose their portfolios to, do the research related to those factors and invest directly in them. This is where Smart Beta can play an important role in asset allocation.

ADHI How should investors think about allocating to Smart Beta as part of their overall equity exposure?

RIC Smart Beta can serve as either a core holding or it could be an exposure management tool in terms of complementing the rest of the equity allocation. For example, if an institution is overexposed to active growth managers, they could manage that exposure by investing in a value-based Smart Beta strategy. In this way, they can continue to benefit from the alpha they are getting from their growth managers, but manage this unwanted factor tilt at the macro level. Smart Beta can also be used as a core allocation, complemented by satellite portfolios of active managers. A diversified multi-factor Smart Beta portfolio, for example, could be part of the core. In general, factor investing allows for scale, and this makes it conceptually appealing for larger investors who still seek higher active share in order to hit return objectives.

In effect, Smart Beta factors are sub-asset classes. It is not equity vs. fixed income anymore, asset allocation discussions now revolve around value equities versus low volatility equities. Credit versus long bonds. This leads to a more refined asset allocation approach.

Figure 1: Re-thinking the core allocation: Traditional vs. Factor-Based (For Illustrative Purposes Only)

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ADHI Factors can perform differently over time, how do you think about investing in Smart Beta factors over a full economic cycle?

RIC Factors perform differently over a full market cycle. Therefore, a multifactor strategy is a prudent way to manage the cyclicality of factors. The nice thing about multifactor portfolios is that you don’t have to think about the economic cycle. Hopefully, it is designed to work throughout various cycles because specific factors outperform during different parts of the economic cycle. Size and Value generally work during periods of economic recovery whereas Quality and Low Volatility will generally work during periods of contraction. So ideally you want to balance those two outcomes by getting equal exposure to those factors in one allocation.

ADHI Digging a little deeper into factors, what are your views on factor timing?

RIC Factor timing can make sense, but we believe it’s best considered on the margins when factors get extreme in price. Like anything else, you need to know the price of what you are buying. I think it is important to monitor the valuation of factors, and if those prices deviate meaningfully to either extreme, then it makes sense to invest or sell out of a factor. But I don’t think this is something that investors should do on a set frequency. It is something that should be monitored and adjusted as investors would for any other asset class.

Disclaimer

Smart beta is a set of investment strategies that uses index construction rules to target specific investment factors - such as value, size, volatility, quality or momentum – in a rules-based and transparent way. Factors are held to be key underlying drivers of the risks and return of an asset class.

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Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.

Investments in issuers in different countries are often denominated in different currencies. Changes in the values of those currencies relative to the Portfolio’s base currency may have a positive or negative effect on the values of the Portfolio’s investments denominated in those currencies. The Portfolio may, but will not necessarily, invest in currency exchange contracts or other currency-related transactions (including derivatives transactions) to reduce exposure to different currencies. These contracts may reduce, take or eliminate some or all of the benefit that the Portfolio may experience from favorable currency fluctuations.

While diversification does not ensure a profit or guarantee against loss, investors in Smart Beta may diversify across a mix of factors to address cyclical changes in factor performance. However, factors may have high or increasing correlation to each other.

A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing.

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