Emerging Topics in Finance

Investment Trends
Quant Strategies
Machine Learning

Smart Beta
Emerging Topics in Finance
Smart Beta
The Market
• Big Three in ETFs: BlackRock (iShares), Vanguard (Vanguard), State Street
Global Advisors (SPDR)
• But over 100 companies sponsor Smart Beta (SB) ETFs
• Indexing
• Market cap
• Equal weight
• Fundamentally weighted: by earnings, by debt-to-equity, by book value….
• Factors
 The Indices: Equity
Index Ticker Established Universe Comment
Dow Jones INDU 1896 US Industrials 30 companies, price weighted
S&P 500 SPX 1957 US Large Cap Concentrated on IT and Financials
Nasdaq 100 NDX 1985 US Large Cap No Financials, utilities, oil, gas, nor
basic material. Technology biased
Russell 3000 THY 1984 US Small Cap Despite small cap, highly correlated to
the S&P 500
Bovespa IBOV 1968 Brazil Large Cap High weight on top 10 components,
few ETFs
Euro Stoxx 50 SX5E 1998 Eurozone Large Cap Biased towards Banks, Industrials and
Services
FTSE 100 UKX 1984 UK Large Caps Bias to Mining and Financials
DAX/MDAX DAX/MDAX 1988/1996 Germany Large/Mid Cap Large weight of top 10 positions
Hang Seng HSI 1969 Hong Kong Large Cap Large concentration on financials
Nikkei 250 NKY 1950 Japan Large Cap Industrials, Consumer Discr., IT
MSCI World MXWO 1968 Industrial Nations Large C 60% US, 8% Japan, 7% UK,…
MSCI Emerging MXEF 2001 Emerging Large/Mid C 60% Asia (24% China, 15% South K)
The Indices
• Sector Indices
• Fixed Income
• Sovereign
• Corporate
• All
• Commodities
• Real Estate
• Alternatives
Indexing: the evolution
• 1st Generation: main market cap indices
• 2nd Generation: Smart Beta
• 3rd Generation:
• Optimized indexing and rules-based investment processes
• Different payoff and risk-return profiles than available with SB
• Factor Rotation….
• …. To reduce the behavioral bias
• Customized indices
Dangers of Indexing (Index Investing)
• …Concern that market cap-weighted funds distort asset prices and leave
investors over-concentrated in large companies…
• …moving from … active funds to cap-weighted funds involves selling stocks
that have been loosing and buying winners…, P. Woolley (LSE)
• Which is the opposite to what investors should be doing… as it adds price
momentum and makes the market prone to bubbles…… is this true?
• Smart Beta may correct that as it systematically leans against the market…
• Smart Beta itself is a contradictory term, Beta by definition is dumb
Dangers of Indexing (Index Investing)
• Initially SB was just about replicating the index with lower costs…
• … later on evolved into not weighing the stocks the same as the index (i.e.,
not by market cap), for ex. equal weights
• Try S&P 500 vs S&P 500 equal weight performance over long periods
• Watch out for ETFs composition/holdings
https://www.ishares.com/us/products/239728/ishares-sp-500-value-etf
https://www.blackrock.com/cl/productos/239725/ishares-sp-500-growth-etf
https://www.invesco.com/static/us/investors/contentdetail?contentId=35933e4f47
062510VgnVCM100000c2f1bf0aRCRD&dnsName=us
Features of Smart Beta
Risk – Return profile of factors
Features of Smart Beta
• And of course the Factor ETFs/Funds:
• Value, Size, Momentum, Low Volatility, Quality
• The factors arm race: 300 factors in 2014!
• The focus now is on managing portfolios by timing factors
• Timing can be achieved through various strategies
• Selling (buying) those that have become expensive (cheap): P/E, P/B, …
• Business Cycle
• …
• Timing Factors is hard
Features of Smart Beta
• Although factors are not new, still some way to go for investors to adopt it
Features of Smart Beta
• The behavioral return gap: herding
Indexing: Factor Rotation
• Actively manage a portfolio based on risk factor allocations
• Risk Premia are not stationary but cyclical
• Factor indices show different return paths in different stages of the market cycle
• It appears that factors exhibit significant alpha and higher Sharpe ratios than the
market-cap index ….. but this outperformance is only reaped in the long term if
investors hold on to their positions
• That means enduring periods of underperformance
• But doesn’t mean you don’t have to move around those factors during the journey
• Behavioral investing results in procyclicality, so rules-based 3rd generation
factor strategies can help with that
Indexing: Factor Rotation
• Multi-Factor Indexes: intelligent risk factor portfolios to match investors
needs
• Diversified portfolios of factors can alleviate the cyclicality in portfolios
• But what does “diversified” mean in a portfolio of risk factors?
• Remember single factors should bear little correlation among themselves
• Rules-based rebalancing deals with price movements in counter-cyclical
manner
• Better-performing factors are cut back and underperforming factors are increased to
theoretical allocation
• Multi-Factor funds are no panacea but they …
• are cost effective and offer transparent diversification (as opposed to stock portfolios)
• Minimize the risk of over-weighting the wrong factors in market cycles (hard to
predict)
Indexing: Factor Rotation
• Long term: multi-factor funds should be less volatile than single factors
• One of first providers was Indexing Research Powerhouse Scientific Beta
• Partnered with Global X to offer multi-factor ETFs
• Combining value, small cap, low vol, momentum
• … “scientific betas methodology then allocates weightings to each of those factors,
combined with periodic rebalancing”…
• BlackRock iShares quickly followed, partnering with MSCI … also offering to
European investors
• Some caveats are in place:
• The optimal allocation of factors is dynamic: Risk – Return profile of such portfolios
(ETFs) depends on the right selection of factors at each point in time…or in the cycle!
• Higher complexity (and/or lower transparency) of these ETFs will normally increase
Total expense ratios (fees)
Indexing: Flexible Factor Rotation
• Some caveats are in place:
• The optimal allocation of factors is dynamic: Risk – Return profile of such portfolios
(ETFs) depends on the right selection of factors at each point in time…or in the cycle!
• Flexible Factor Rotation is basically Factor Timing
• Dynamically allocate into an available pool of factors as a function of the market cycle
• Key difference to static weighting is extra risk adjusted performance through
diversification but also through performance timing
• Factors also exhibit persistence and momentum in the short term that can be captured
• Problem: accurately forecasting the market cycle
• Most active factor timing strategies / funds do not stand up to promised results
• Therefore: do not forecast the cycle! Just position according to current market cycle
Indexing: Flexible Factor Rotation
• Different factors show different Risk – Return profiles in different stages of
the cycle, so ….
• Define your exposure accordingly: momentum / small caps in bull cycles, low vol or
yield in bear cycles
• All you need to do is to correctly identify the current cycle
• Reliance on technical indicators: moving averages, RSI, …
• Main difference with 1st and 2nd generation indexing is that 3rd flexible factor
rotation dynamically and tactically alter the portfolio betas
Indexing: Flexible Factor Rotation
Indexing: Flexible Factor Rotation
Dynamic Risk: Target Volatility
• Standard indexing (S&P 500), regardless of the weighting scheme (S&P 500
Equal Weight), and Static Smart Beta remain highly exposed to systemic risk
and large drawdowns (look at the financial crisis or the dotcom bubble)
• Risk-based strategies aim at controlling risk to deliver superior returns
• Target volatility indices + risk control indices
• Dynamically adjust equity exposure in the face of market distress or volatility
• Indices that target a specific level of volatility -> rules-based rebalancing to safe assets

• Different ETFs to target different volatility levels, depending on investors preferences

• FTSE Volatility Target Index Series, Dow Jones Volatility Risk Control Indexes
Indexing: Flexible Factor Rotation
Indexing: Flexible Factor Rotation
Indexing: Flexible Factor Rotation
Dynamic Asset Allocation: Best of Assets
• Seeks to reduce equity market drawdown by tactically adjusting equity
allocation with the market cycle
• It is another rules-based strategy shifting weights between equities and fixed
income, depending on market signals, but always fully invested
• Within a calendar year, monthly rebalancing seeking the best risk-return
combination based on historical returns, volatilities and correlation….but
shifting more weight to the best performing asset (momentum-based)
• At the end of calendar year, rebalance back to 50%-50% (counter-cyclical)
• Example: Dynamic US Allocation Index, by NYSE and MYRA Capital
• Underlyings: NYSE US Large Cap Equal Weight Index (NYLGCAPT) + NYSE US 10 y
Treasury Future Index (AXTEN)
Indexing: The Behavioral Return Gap …
… that could be reduced or closed with rules-based investing
Indexing: The Death of Traditional Portfolios …
… to Factor Portfolios
Active Investing in Passive Products
Alternative ETF Strategies
• Long/Short: equal long and short exposures, “market-neutral”. Variations:
• Positive net long exposure, or 130% long / 30% short, 120 / 20, …
• ETFs linked to these strategies are quite discretionary in the long / short % but also in
their stock selection
• Global Macro: invests in securities whose price fluctuates based on economic policies or
macroeconomic shifts or flows of capital
• Currency, interest rates, equity, bonds, commodities
• Volatility:
• Alpha: option strategies around the volatility term structure
• Beta: low-volatility stocks
Active Investing in Passive Products
• Managed Futures:
• Closely related to Commodity Trading Advisors. Futures trading to seize opportunities
• Not only commodity but also financial and FX futures
• Standard CTA indices are not a good benchmark
Advantages of Alternative ETFs
• Hedge Fund performance dispersion: picking the right hedge fund and the right
manager is critical. Then, get access to the strategy via the right ETF
• Alternative ETF fees tend to be higher than in standard smart beta ETFs: average 1%,
but can go up to 3%
• But you have “partial” access to sophisticated strategies, skip performance fees and
lock-ups
Active Investing in Passive Products
• Managed Futures:
• Closely related to Commodity Trading Advisors. Futures trading to seize opportunities
• Not only commodity but also financial and FX futures
• Standard CTA indices are not a good benchmark
Advantages of Alternative ETFs
• Hedge Fund performance dispersion: picking the right hedge fund and the right
manager is critical. Then, get access to the strategy via the right ETF
• Alternative ETF fees tend to be higher than in standard smart beta ETFs: average 1%,
but can go up to 3%
• But you have “partial” access to sophisticated strategies, skip performance fees and
lock-ups
https://www.etf.com/channels/alternatives-etfs
Customized Indexing
o Individually created investable underlying, or…
o Individually reshaped investment benchmark, or simply….
o Indices developed for individual needs of clients that don’t want to be bound
to invest in the traditional indices/ETFs
o MSCI, S&P, FTSE Russell, … MSCI is currently calculating > 7000 ‘customized
indices’ form >700 clients globally
Equity
• Existing benchmarks can be adjusted towards a more individual focus to
avoid concentration risks or sector overweighting
• Nasdaq 100: Apple + Alphabet ≈ 10% and top 10 positions ≈ 50%
• Swiss Market Index: top 3 positions ≈ 58%, Nestle a ≈ 22%
Customized Indexing
Trend Benchmarks
• Customized indices on thematic investments.
• Some times they don’t last other times they strike brilliant market timing:
• HACK ETF, tracking the ISE Cyber Security Index, created with PureFunds
• 12 days after trading debu, Sony declared that huge amounts of sensible client data was stolen, which
brought HACK USD millions of inflows. In Oct 2016, HACK’s AuM were at $ 749 million, gross management
fee 0.75% = $ 5.6 million!!
Fixed Income
• Ordinary index weighted by outstanding debt
• iShares Global Government Bond ETF, tracking Citigroup G7 index: US + Japan ≈ 65%
• Sovereign indices: weight by GDP growth, more tied to fundamentals and forward-looking
• Emerging markets normally higher allocation
• Corporate indices: weighting by cash flow or adjusted assets
• Citi RAFI World Corporate Investment Grade Bond Index, reflecting a company’s debt service capacity