By: Rolf Agather, CFA, Managing Director of Research
As part of our ongoing series on smart beta, we’ve used the findings from our Smart Beta: 2016 Global Survey Findings from Asset Owners to document the growth of smart beta and the investment outcomes driving interest. Now, through our work with large institutional investors globally–particularly several that have established two to three-year track records–we examine how asset owners are actually using smart beta indexes.
Every asset owner has unique goals and processes, yet our research has identified four common themes or drivers behind asset owners' decision to use smart beta indexes that emerge when looking across the spectrum: Increasing Investment Transparency, Managing Portfolio Cost, Improving Investment Outcomes and Enhancing Investment Liquidity and Investment Capacity.
These smart beta adoption drivers are consistent across asset owners we have worked with, but key differences can be found in how the funds view, analyze and vet indexes as well as how they enhance or re-construct their portfolios. Let’s look at three fictional examples:
|Case Study 1: Transparency, Investment Outcomes and Cost|
|Asset Owner||$50 - $60 billion sophisticated plan|
|Index Choice||Russell Fundamental US Large Company Index benchmarked to the Russell 1000 index|
The main driver of the public plan’s adoption of smart beta was to increase investment transparency and improve investment outcomes – specifically beating its benchmark – while reducing portfolio costs. The plan was also seeking investments that could help provide additional portfolio diversification while complementing existing market cap weighted index allocations. The plan is looking to gradually shift its investment allocation towards lower cost internally and externally managed strategies designed to capture certain factors or risk premia that they expect to have a long-term positive excess return. The plan has increased its initial allocation to an investment strategy based on the Russell Fundamental US Large Company Index from $500 million to $1 billion. This fundamental index has performed in line with its respective benchmark index. While fundamental indexes are designed to have a long-term exposure to the value factor, over shorter periods, the magnitude of this exposure varies. As such, the Russell Fundamental US Large Company Index has outperformed the Russell 1000 Value Index as shown below.
Performance of the Russell Fundamental US Large Company Index, Russell 1000 Index and Russell 1000 Value Index
|Case Study 2: Avoid Repeat of the Consequences of the 2007-2008 Crisis|
|Asset Owner||Very large ($180 billion+) public plan|
|Index Choice||Due to ongoing market volatility, the plan selected the Russell 1000 High Efficiency Defensive Index (Russell 1000 HEDI) which is designed to provide exposure to Low Volatility and Quality Factors in an efficient, transparent and turnover-controlled way. The index comprises securities that have lower volatility, higher return on assets, lower relative leverage and fairly stable earnings over time.|
The plan’s decision to allocate according to its selected factors helped curtail the impact of a market downturn. Through this period, the Russell 1000 Index was down 5.41% whereas the Russell 1000 HEDI Index was down 1.71%.
|Case Study 3: Manage Risk|
|Asset Owner||A very large UK-based public plan with a large degree of flexibility and relatively low risk tolerance|
|Index Choice||The plan’s own modelling suggested that the cost of building targeted solutions to match risk utilizing passive instruments could lead to savings—savings that could be re-invested for the benefit of members. After evaluating various low volatility indexes, the plan selected the FTSE All-World Minimum Variance Index as the benchmark for its public equity investments. The FTSE All-World Minimum Variance Index (part of the FTSE Global Minimum Variance Index family) has been designed to minimize index volatility. Additional constraints are applied to avoid concentration in individual stocks, sectors, and countries. A practical minimum variance index is a careful blend of constraints that trade off volatility reduction and diversification, where the constraints provide a safeguard, but do not unduly affect outcomes.|
Since the plan’s adoption of the FTSE All-World Minimum Variance Index in July 2014, the index has demonstrated higher levels of risk-adjusted index return than its cap-weighted benchmark, as shown in the graph below.
Risk Adjusted Return: FTSE All-World Minimum Variance Index and FTSE All-World Index
These three examples illustrate the variety of approaches taken by asset owners in using smart beta indexes. We expect that the number of smart beta index implementations by asset owners will grow, and those currently in place will gain greater practical experience as time goes by. We hope to examine more of these case studies in the future.
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