Call it ‘systematic beta', ‘smart beta' or whatever you prefer, says Toby Hayes, the discipline is set to be a vital cog in the next generation of multi-asset investing
So how do you like your ‘beta'? Over the past few years, there has been no shortage of articles, discussions, speaker panels, products and marketing packs alternately referring to ‘smart beta', ‘alternative beta', ‘scientific beta', ‘active beta', ‘strategic beta' and half a dozen other variants.
Personally, ‘systematic beta' is the term that seems best to capture the process of investing in persistent market-neutral risk premia, accessible through rules-based trading strategies, based on fundamental economic rationales.
While this etymological squabble may seem at best academic and at worst infuriating, it reflects a very real attempt to articulate a new form of investment strategy - one that serves the needs of both investors and their advisers.
In the wake of the financial crisis of 2008/09, investors and advisers have been seeking alternatives to classic portfolio construction - solutions that help them achieve their outcomes rather than tracking an index.
As many investors painfully remember, in many portfolios developed prior to 2008 - a lot of which incorporated well-diversified, non-correlated asset classes - the array of investments were found to be moving in concert and most, unfortunately, in the wrong direction. Since that time, accessibility to new asset classes have emerged, particularly in the alternatives space, to help shore up portfolio diversification and long-term stability.
These enhancements are to be applauded yet there is a further step to take to address the underlying issues in traditional portfolio construction. Instead of simply adding new diversifiers to traditional asset allocation, the traditional methods of building a well-diversified portfolio that can generate solid investment returns have begun to show their limitations.
Correlations between traditional asset classes have been climbing, meaning investing in a traditional combination of stocks and bonds may no longer create a truly diversified portfolio. And without sufficient diversification, unforeseen risks may be lurking within portfolios that have not been adequately addressed by traditional approaches.
The market stresses that emerged during and after the financial crisis have made true portfolio diversification and risk management all the more important. Moreover, investors have benefited from the long-term trends of falling interest rates and rising stock prices - yet many of these same investors now have concerns about the future returns of these asset classes. If the trend reverses, it could mean overall market returns may turn out to be less attractive over the longer term.
Evolving financial markets require investors to reach for new tools - particularly as our understanding of the sources of returns becomes more precise. Over the past 85 years, investment professionals have gone from believing security selection, also known as ‘alpha', was the sole source of investment returns to understanding there are different underlying sources of return.
Identifying traditional ‘beta' - the returns ascribed to broader market performance as opposed to security selection - was the first step in our evolving understanding of returns. Academic research has brought us a deeper appreciation of what beta comprises.
Systematic beta exists due to structural inefficiencies or behavioural anomalies in the market - phenomena related to value, momentum, the shape of the yield curve or liquidity, for example. Many of these factors are not themselves new, but we now have ways to build portfolios around them, using trading strategies or swaps that were not previously available in a liquid, cost-effective way.
The existence of these rules-based trading strategies that isolate specific factors has allowed us to move from the academic world of identifying and classifying risk premia, or any investment that is expected to outperform the risk-free rate, to investing in them through systematic beta strategies.
These tools, we believe, open up a new way for investors to build portfolios that are more diversified than those that use traditional methods. Furthermore, systematic beta is, in our view, a source of returns that is persistent over time, investable and liquid - and can be implemented systematically. Critically, however, performance within individual systematic beta categories can vary dramatically, depending on how the strategy is executed, making expert strategy selection crucial to adding value.
Another layer of diversification
Systematic beta strategies provide potential benefits that may result in more efficient portfolios with enhanced return and risk characteristics in three main ways. They provide low correlation to traditional financial markets, they act as a source of additional return generation from non-traditional sources and they can help investors manage volatility and tail risk.
Perhaps most importantly, systematic beta can potentially provide diversification not only from traditional asset classes but also among the various categories of systematic beta. Generally, each systematic beta category has historically had low correlation to traditional asset classes and low correlation to other systematic beta categories.
At the same time, correlations between traditional assets have generally strengthened over the last decade. This means that, during a major drawdown, portfolios containing primarily traditional beta may provide minimal downside protection and may not benefit from diversification. Meanwhile, correlations between traditional and systematic beta tend to be near zero and stable through time -even during periods of heightened market volatility.
What might this all mean in practice? There are a broad number of ways in which systematic beta can be implemented but, as an example, let's look at Franklin Templeton's approach to multi-asset strategies.
The starting point for the positioning of the portfolios is the development of broad macroeconomic, forward-looking themes that ultimately drive portfolio construction. The actual construction of our portfolios is, however, fundamentally based on diversifying the risk factors, not the asset classes, and we believe using risk factors rather than asset classes is the most precise means to gain exposure to macro themes. That means segregating and isolating individual risk factors within asset classes and finding ways to invest (or de-invest) in them separately.
Equity factors give the clearest example of this. Within traditional asset allocation, investors often tilt their equity portfolio to style factors, such as value or quality. The outperformance of these factors (and impact on the wider portfolio) will, however, be dwarfed by the wider performance of the equity market.
The decision to allocate to style factors becomes independent of one's broad equity allocation, and one can set the allocation to the style factor to be commensurate with one's conviction as opposed to being constrained by the portfolio's broad equity allocation.
Yet systematic beta investing is not without its pitfalls. In the traditional asset class space, the world of strategic asset allocations with tactical overlays is well-rehearsed and settled as the standard framework for portfolio design. Yet the approach struggles to cope as the opportunity set is vastly expanded to include systematic factors.
Also, systematic factors are expected to generate a positive premium and therefore must have a sound economic rationale for their existence. As exposure to many systematic factors is gained by ‘design' of systematic trading rules, the very existence of the systematic factor can be questioned when back-testing and data-mining are the only proffered evidence.
Similarly, model risk aside, systematic factor investing can also be cyclical and dependant on market regimes of volatility growth and inflation as well as also being capacity constrained. All of these issues make design, selection and forecasting a non-trivial issue when including systematic factors in the portfolio, suggesting that significant research and resources are still required when allocating to these factors. In this brave new world, this, at least, is one constant and similarity with more traditional asset allocation that has not been washed away.
Investing in systematic factors does not represent a panacea for cross-asset investors but it does represent a seismic shift in portfolio design and philosophy. The decomposition of portfolio risks on a factor basis rather than on an asset class basis will often require a complete change of mind-set for the cross asset investor but, if achieved, will allow for more targeted portfolio objectives, realigning expected risks and rewards across the portfolio and, finally, giving true meaning to the word ‘diversified'.
Toby Hayes is portfolio manager of the Franklin Diversified Income Fund
