active passive and smart beta part 5 smart beta strategies
This is final part of the 5-part series on Active, Passive and Smart Beta strategies.
So far, we have discussed Active and Passive strategies and did a detailed comparison - Active vs Passive Investing. We also introduced the concept of Factors, Risk Premium and Multi Factor models (Systematic Factors and Risk Premium).
Factor investing is the core of Smart Beta strategies. More specifically, the ability to harvest the underlying risk premium of “Systematic” Factors if what Smart Beta is all about.
In Part 1 (An Introduction) we looked at the overall investment strategy landscape and how these 3 styles fit into it.
Let’s do a quick recap.
Active, Passive and Smart Beta - these 3 styles broadly cover the entire gamut of Investment strategies. Note that Active and Smart Beta styles are very broad categories themselves.
Comparing these strategies along the dimensions of Manager Discretion, Fees and trading costs and Capacity, we get the following table:
And the figure below provides a visual representation:
Smart Beta is sometime misunderstood as Factor Indices such as Nifty 200 Momentum 30 Index which takes exposure to the Momentum Factor. While these indices are indeed Smart Beta indices, Smart Beta strategies are not limited to these indices.
A more general definition of Smart Beta strategies would be as follows – Any transparent and rule-based strategy that aims to harvest factor risk premium beyond the market risk premium.
As can be seen from the figure above, the Smart Beta spectrum is fairly broad. On the left, you have single-factor indices (and strategies replicating them) while on the right, you can have multi-factor strategies with complex and esoteric factors.
Let’s look at some examples:
An Index Fund that aims to replicate Nifty 200 Momentum 30 Index - UTI Nifty200 Momentum 30 Index Fund). This strategy has exposure to 2 factors – Market and Momentum. This strategy is on the left of the Smart Beta spectrum. Interested readers can check the methodology of Momentum Index here.
Now consider a Fund that goes equal weight on top 30 Value stocks (unlike the Index Fund which is market-cap weighted). Basically, in this stylized example, stocks from Nifty 500 are screened based on their P/E ratio and portfolio is constructed by equally weighting bottom 30 stocks. A new portfolio is created every quarter. Exposure is primarily to Value and Market factors. This strategy lies in the middle of Smart Beta spectrum.
Now let’s consider a Value and Momentum Fund where the weights are based on the strength of Value and Momentum signals combined. Suppose each stock in Nifty 500 is assigned a Value score and a Momentum score. We take an average of both the scores (standardized) and arrive at the final score. We pick top 30 stocks and weight them according to the score. This will have exposure to Value, Momentum and Market Factor. This is an example of a strategy which is towards the right end of the spectrum.
All these are long-only strategies and hence Market factor is implicit. Any strategy that is long-only will always have exposure to the market Factor. In order to remove the impact of Market, we have to resort to long-short portfolios as discussed in Systematic Factors and Risk Premium.
The core idea is that Smart Beta strategies can be constructed in multiple ways to take the desired exposure to one or more factors (across one or more asset classes) and these factors need not be limited to the known ones - Value, Momentum, Size, Low Volatility and Quality.
Many managers use multi-factor models to forecast risk and return and use that as an input for portfolio construction. We would club these strategies in the “active” bucket as there is an explicit notion of forecast (views) involved.
While Smart Beta strategies can be constructed using multiple Factors, it is important that the underlying factors are systematic. In other words, if the underlying factors are not systematic, the beta isn’t smart.
Just to quickly recap, systematic factors are those that cannot be diversified or arbitraged away. In other words, the risk premium associated with these factors will not disappear.
If a strategy is constructed using factors that are not systematic, the risk premium will soon vanish due to arbitrage forces. Simply put, an intelligent manager who finds a unique undiscovered factor can outperform for a while. But soon, it will be arbitraged away.
So how do we know if a particular factor is systematic? Data mining or short-term anomalies can make a factor appear systematic when they are not. We address this question in the next section.
As discussed in the previous section, the key to constructing a Smart Beta strategy is to identify systematic factors.
Investment industry is flooded with factors ranging from technical indicators, fundamental indicators, alternative data signals. Which one work and which doesn’t? More importantly, which factors will continue to work in the future?
In Part 4 (Systematic Factors and Risk Premium), we discussed 4 factors – Size, Value, Momentum and Low Volatility. We saw that Size premium has all but vanished. On the other hand, Value, Momentum and Low Volatility premium appears to be robust.
Identifying a systematic factor that will continue to earn a positive premium in future is a challenging task. And to exacerbate the matter further, even systematic factors change over time as markets go through major structural shifts. Size might have been a systematic factor till 80s but lost its mojo post that (maybe due to technology revolution). Research has shown that Value did not command a premium is earlier half of previous century.
Having said that, Factor recipe is straightforward:
Given this recipe, Value, Momentum and Low Volatility factors make the cut. Investors can take exposure to these factors along with the market factor (and duration and credit risk factors for bonds).
What is the optimal exposure and how to construct such portfolios? Well, these are topics for another day.