We have published the quarterly index factsheet for the Elston Strategic Beta Global Minimum Volatility Index: a multi-asset risk-based strategy. The index strategy is designed to allocate to a diverse range of asset classes so as to minimise the volatility of the overall strategy.
View Factsheet Learn about Elston Indices Visit ESBGMV Index<Go> on the Bloomberg Terminal
Smart beta strategies are “smart” because they take a scientific, quantitative and objective approach to investing by combining a range of index-tracking ETFs with different market risk or “beta” exposures. In contrast to the opacity of hedge funds, dynamic allocation “smart beta” investment strategies should do what they say on the tin. Elston runs a number of diversified multi-asset investment strategies, two of which have been offered as indices for asset owners and investment managers to benchmark against or track. Chart 1: Risk and Return 2016 Source: Elston, Bloomberg, all in GBP Looking at outcomes Our multi-asset Global Max Sharpe index (Bloomberg: ESBGMS) did what it said on the tin delivering a Sharpe ratio (our primary measure of success for this strategy) of 2.06 for 2016, compared to 1.94 for Equities, 1.90 for Bonds and 1.45 for Commodities. On a returns basis (our secondary measure of success) the strategy returned 23.58% for the year, compared to 28.35% for equities, but with volatility of 10.35% compared to 15.45% for equities. Put differently, the strategy captured 83% of equity returns with just 67% of equity risk. Chart 2: Elston Multi-Asset Max Sharpe (ESBGMS) 2016 Outcome Source: Elston, Bloomberg, all in GBP Our multi-asset Global Min Volatility index (Bloomberg: ESBGMV) also did what it said on the tin whilst maintaining exposure to a broad set of return-seeking asset classes. The realised volatility (our primary measure of success for this strategy) for 2016 was 7.08%, compared to 15.45% for equities, 13.64% for bonds and 25.28% for commodities. Our dynamic asset allocation approach minimised portfolio variance whilst harvesting returns. On a returns basis (our secondary measure of success), the strategy returned 18.62% for the year, compared to 28.35% for equities, but with volatility of 7.08% compared to 15.45% for equities. Put differently, the strategy captured 66% of equity returns with just 46% of equity risk. Chart 3: Elston Multi-Asset Min Volatility (ESBGMV) 2016 Outcome Source: Elston, Bloomberg, all in GBP Theory and practice Our strategies constituent parts are ETFs representing a broad range of asset classes and geographies. The Sharpe of our Global Max Sharpe strategy’s whole is greater than the sum of its constituent parts. The Volatility of our Global Min Volatility strategy’s whole is less than the sum of its constituent parts. And that’s the intention. A low cost more consistent alternative to hedge funds? Hedge funds were popular because they provided differentiated returns and mitigated risk. In 2016, Hedge Funds returned 1.35% with volatility of 3.56%. Put differently, on average they captured just 5% equity returns, despite taking on 23% of equity risk. We plot out equity return capture (return relative to global equity return) and risk outlay (volatility relative to global equity volatility) for the main asset classes, our strategies and HFRX (all in GBP) in the summary matrix below. Chart 4: 2016 Return Capture vs Risk Outlay Source: Elston, Bloomberg
The problem with many hedge funds is that they are not doing what they say on the tin. They aim to provide diversified differentiated returns – but their process, statistically, amounts to trial and error, fraught with subjective bias. We seek to achieve similar outcomes, but using a clinically quantitative approach. To paraphrase a famous composer: “At the end of the day, it’s just maths.” What next? The Elston Strategic Beta multi-asset indexes were launched in December 2014. They are priced daily with index values available for free, factsheets are published daily. Our research strategies and indices are available for licensing.
A panel session at the Inside ETFs Europe 2016 Conference examined the renewed interest in Liquid Alternatives. This article draws out and expands on some of the key findings from the panel discussion of the same title. The role of alternatives in portfolio construction The role of “alternative” asset classes in portfolio construction has traditionally been to provide differentiated asset returns that reduce overall portfolio volatility through diversification. Alternative asset classes can be broadly defined as non-equity and non-bonds, so typically includes hedge funds, property, commodities, infrastructure and private equity, and subsets of those groups. Lessons from the global financial crisis This classic Markowitz-style portfolio construction approach, based on single period mean variance optimised models was severely challenged in the global financial crisis, when diversification failed to protect assets in the short run (correlations trended to one), and risk-return opportunities became more binary (risk-on/risk-off). Assumptions challenged More specifically, some key assumptions on correlation, liquidity and time horizons that underpin portfolio construction theory required closer scrutiny. Firstly, correlations are unstable, particularly over shorter time horizons. This means that while a static approach to a diversified asset allocation may be adequate in the long run for the long run, in the short run diversification can fail to provide any protection to a portfolio. Hence the need for a tactical asset allocation approach that is dynamic. Dynamic means adapting to the fact that correlations between asset classes are different in the short run to how they are in the long run, and remain in constant flux. It’s therefore important to understand the role and correlation of alternatives to other asset classes across a time horizon that is relevant to an investor, as not all (in fact very few) investors are endowments with infinite time horizons. Secondly, liquidity matters, and matters more when needed most. While portfolio theory assumes perfect liquidity to move between asset classes, the relevance of liquidity became all too apparent in the financial crisis both from a timing perspective and a counterparty perspective. From a timing perspective, the gating of investors in certain hedge funds, and the relevance of redemption notice periods – whether daily, monthly, quarterly or annually – became all too relevant. From a counterparty perspective, solvency, capital structure and legal title became a primary concern. Finally, time horizon matters. For investors with a long-run time horizon who had no need to access capital and could weather extreme market volatility, there was sufficient risk budget not to worry about near-term correlations and liquidity constraints. But for those that needed to access capital in the near to medium term, or wished to dial-down their exposure to all risk assets in the face of potential market dislocation, these factors could not matter more. Industry response Once the dust settled, the industry response to client concerns was to consider how to offer alternative strategies (for the same diversification reasons as before), but with some hard lessons learned. Strategies had to be sufficiently flexible to be adaptive to changing market circumstances, and sufficiently liquid to be bought and sold on a daily basis. “Liquid alternatives” therefore became a buzzword for strategies that can 1) from a portfolio construction perspective, provide uncorrelated returns to traditional asset classes; and 2) from a portfolio implementation perspective, provide daily liquidity. Put differently, liquid alternatives are products that enable investors to trade “anything other than conventional beta”, according to Jean-René Giraud, CEO of Trackinsight, a European ETF research provider that is part of Koris International. Liquid Alts – delivered as mutual funds The growth in “liquid alt” was focused initially in the US mutual fund space (and were sometimes known as 40 Act funds as they were governed by the US Investment Company Act of 1940). The nature of investment strategies offered was therefore governed by what was permissible under the 1940 legislation – for example the requirement to offer daily liquidity, and to calculate a daily NAV. However, this also meant constraints around concentration, excessive leverage and short-selling. While these constraints were more restrictive than private/non-registered hedge funds, this sub-optimality was considered outweighed by investor demand for daily liquidity. Following the financial crisis, there was explosive growth in liquid alt funds, as illustrated in Fig. 1, below: Figure 1: Growth in Liquid Alt Mutual Funds (US) Note: The chart combines the Morningstar Alternative Mutual Funds and Morningstar Non-Traditional Bond Funds sectors to represent a Liquid Alt mutual fund sector.
Source: Spouting Rock, Morningstar Direct, as at 31st October 2015. Morningstar subdivides liquid alt funds into the following sub-sectors: Managed Futures, Long-Short Equity, Multi-Alternative, Market Neutral, Nontraditional Bond, Multicurrency, Bear Market. Managers of liquid alt funds ranged from specialist boutiques to retail versions of established hedge fund managers. Growth in AUM in liquid alt mutual funds has since tapered off possibly because the liquid alt exposure is becoming more readily available – to institutional and retail investors alike – through Exchange Traded Products (ETPs). Liquid Alts – delivered as ETPs The growth in Liquid Alts continues in the ETP space which has enabled rapid innovation in the breadth and depth of the range of strategies available. With TERs of 0.20% to 0.60% for ETPs, compared to TERs of approximately 2.00% for 40 Act funds, there is a compelling cost efficiency too. This is a key reason that institutional investors are looking at liquid alt ETPs as a lower cost alternative to hedge funds with a similar portfolio function, according to Jay Pelosky of J2ZAdvisory a New York-based global investment advisory firm. The number of liquid alt (including Smart Beta) index strategies available to fulfil the role of of providing differentiated returns to traditional asset classes is expanding rapidly on both sides of the pond:
While the range of products available is far greater in the US than in Europe at this stage there is potential for Europe to “leapfrog” and catch up in terms of innovation and development given the high level of research in alternative strategies from institutional investors, index providers and academia, according to Mr Giraud. Liquid Alts – delivered as Model Portfolios Retail investors are not limited to alternative mutual funds, or alternative ETPs. Liquid Alt strategies can be made available via managed accounts which are unconstrained by the parameters of the 1940 Act or individual ETP construction. One of the key enablers for this was the investment into platform technology by North American brokerages that made Model Portfolios readily manageable, according to Suzanne Alexander of Cougar Global Investments, a tactical ETF global investment strategist focusing on portfolio construction with downside risk management. So whether as an investment strategy in itself, or an alternative part of traditional strategy, liquid alternatives are helping to redefine portfolio construction. In this respect, Europe is lagging with platform providers slow to offer ETFs, let alone ETF Model Portfolios (“EMPs"), according to Giraud. UK Platforms – ETF Ready? In the UK, platform providers remain focused on mutual funds as a way of delivering investment allocation to clients, and the bulk of investment research is skewed to fund manager research, rather than ETF research. Novia Financial is one of the few platforms to offer not only traditional fund services, but is actively seeking to improve adviser access to ETFs, through technology upgrades. Platforms that are “ETF enabled” can provide advisers the tools, products, and cost structure they need to compete on like for like terms with robo-advisers which typically use ETF Portfolios, aggregated trading, and fractional dealing to deliver low-cost scalable investment solutions. With this technological parity, advisers can then differentiate themselves on the core services that robos can’t offer: financial planning/wealth structuring (typically more material than investment allocation), face to face support and a relationship based on trust. Broadening the portfolio construction toolkit Retail investors continue to seek ways to diversify their portfolios. Institutional investors are losing patience with Hedge Funds’ lack of “value for quality” evidenced by the material redemptions from hedge funds (some $14.3bn net outflows in 1q16 alone, according to Preqin). This means there is growing demand for liquid alts both from the top down and the bottom up, according to Pelosky. Funds formerly allocated to hedge funds will have to find a home, and a reinvigorated lower cost liquid alt ETP sector could be in the running to capture part of it. Notes: Participants in the panel discussion on this topic included: Henry Cobbe, Elston Consulting (moderator) Susanne Alexander, Cougar Global Investments Jean-René Giraud, Trackinsight Jay Pelosky, J2Z Advisory NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credit: Elston Consulting. Chart credit: Spouting Rock
A survey published this week of 250 institutional asset owners with AUM in excess of USD2 trillion suggests that there is continued growth of interest in reviewing Smart Beta strategies. The survey is published by FTSE Russell and is available here. It suggests that 36% of institutional asset owners are currently evaluating smart beta, up from 15% in 2014. This implies the potential for large inflows into smart beta strategies over the coming 12-24 months. What is smart beta? From an index construction perspective, if beta is defined as index-based investment strategy constructed using a cap-weighted approach (size factor), smart beta can be defined as an index-based investment strategy using an alternatively weighted approach (any factor other than size). From a portfolio construction perspective, smart beta can be defined as an asset allocation strategy constructed using different optimisation techniques to combine a range of index-based investment strategies. What the factor? Risk and return can be broken down into many contributing factors. Analysing factors requires the ability to statistically distil, isolate, and observe a factor for significance. There are therefore potentially thousands of factors, depending on your ability to analyse them, which could include aside from the obvious (size and volatility), quality, momentum, value, liquidity, profits, dividend yield, leverage, etc which make up the components of earnings and/or the cost of capital which classically define a company’s value. The broadening and deepening of data availability and accelerating computing power is facilitating the growth in this quantitative approach. How do factors help? Buying the (cap-weighted) index for an asset-class (e.g. S&P 500 NYSEARCA:SPY, NYSEARCA:IVV (US); LON:CSPX (UK)) could be seen as a straightforward “passive” approach. Through a factor lense, however, it looks like a blind overweight of a size factor. Size factor may outperform in some market conditions and underperform in others. So while asset owners traditionally thought of asset allocation in terms of geographies and asset classes, they are starting to consider portfolio analysis and construction from a factor perspective. It’s no secret that sovereign wealth funds have been early adopters of smart beta investing: the transparency of a rules-based approach is additionally attractive. Is “smartie” the new “hedgie”? Like the original attraction of hedge fund, return enhancement and risk reduction are the primary motivations for reviewing Smart Beta strategies, according to the FTSE Russell report. Unlike hedge funds, cost savings are an attraction too. Sounds familiar? One of the original motivations for including hedge funds in a portfolio was for return enhancement and portfolio risk reduction through the inclusion of an uncorrelated asset. This ostensibly required exceptional skill, and hence exceptionally high fees. But the mantra supported the exponential growth in hedge funds from niche to mainstream from the early 2000s. Arguably, smart beta strategies can serve the same purpose from a portfolio construction perspective, but using a systematic rules-based approach that replaces manager risk (unpredictable, rarely consistent), with model risk (predictable, consistent). Combined with ego-free fees, it’s no wonder that there is so much interest in this investment approach. Flexible delivery? Furthermore, unlike hedge funds, smart beta strategies can be delivered to in-house managers, segregated accounts,– the equivalent of being able to “enjoy in your own home” – as well as ETPs and CITs (Collective Investment Trusts). Relative to hedge funds, this creates greater transparency about the counterparty risk you are taking. Has the switch started already? As if on cue, two stories on the same day this week illustrate the point. In the UK, some listed hedge funds are reported as losing two-thirds of their assets as performance disappoints and expensive alpha proves elusive. Separately, in the US there are reports of further M&A activity in the smart beta space with Hartford Funds, a $74bn asset manager acquiring Lattice Strategies, a San Francisco-based smart boutique with $215m AUM. This is the latest in a series of acquisitions by large asset managers of quantitative boutiques. What kind of smart beta equity strategies are available? Smart beta equity strategies for USA (NY-listed) and world markets (London-listed) include factor based strategies from BlackRock’s iShares® such as Quality (eg NYSEARCA:QUAL (US) & LON:IWQU (UK)), Value (eg NYSEARCA:VLUE (US) & LON:IWVL (UK)), Momentum (eg NYSEARCA:MTUM (US); LON:IWMO (UK)), and Size (eg NYSEARCA:SIZE (US); LON:IWSZ (UK)). What about multi-asset? Our approach has been to focus on risk-based portfolio construction which is why we launched our multi asset Global Max Sharpe Index (ticker ESBGMS) and multi-asset Global Min Volatility Index (ticker ESBGMV) back in December 2014. Our view is that smart beta is a new and powerful part of the portfolio construction toolkit. Conclusion We see smart beta as a diversifier for classically constructed portfolios and as a flexible tool for analysing and managing factor exposures at different stages of the market cycle. If the large institutional asset owners follow through their interest in smart beta with mandates, it will be an investment style that is impossible to ignore. NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credit: FTSE Russell
The portfolio puzzle The Rubik’s cube has become a popular metaphor for the marketing teams of ETF providers. With good reason. For each client there’s a portfolio construction puzzle to be solved with building blocks, representing geographies, sectors, asset classes, factors and styles. There has been rapid expansion from providers of ETFs tracking main-market indices, with the largest institutional providers capturing the lion’s share of flows, owing to their ability to deliver on four key ETF governance criteria – consistency, liquidity, transparency and, of course, price. This means that ETFs for main market cap-weighted indices are increasingly commoditised. After all, there doesn’t seem to be anything overly smart about replicating market beta, other than the smartness of saving on fees relative to 'closet-tracker' active funds. Traditional cap-weighted index investing is a preference: either out of philosophy or necessity. Innovation means smarter? Hence R&D of institutional investors, index providers and ETF manufacturers alike has focused more on “smart beta”. This has triggered a slew of innovation – both superficial and substantive. At a superficial end, age-old alternative weighting strategies (eg value indices that screen stocks for low book values, or dividend-weighted indices) have been rebranded as being “smart”. In these cases, for “smart” read “non-market-cap weighted”. In fairness, this rebranding is part of broadening of alternative weighting strategies that are factor-based. More substantively, research programmes such as EDHEC-Risk Institute’s Scientific Beta have been instrumental in promoting fresh thinking the field of both factor-based and risk-based smart beta strategies. Factor-based approach As a result, providers are focusing on making building blocks smarter. Instead of relying on the ‘traditional’ factor of market capitalisation for index inclusion, smart beta indices (and related ETFs) look at alternative factors: book value, dividend yield, volatility, for example. In that respect, the FTSE Russell 1000 Value Index launched in 1987 is probably the oldest factor index on the block. More recent factor indices are stylistic: Both iShares (Oct-14) and Vanguard (Dec-15) havelaunched global equity factor ETFs focusing on Liquidity, Min Volatility, Momentum and Value. The sophistication of factor-based index construction will continue to increase with the increase in data availability and computing power. Risk-based approach Portfolio strategists meanwhile can apply quantitative rules-based approaches to portfolio construction, creating static or dynamic asset allocation strategies from a growing universe of both cap-weighted and alternatively-weighted index tracking funds. These strategies – such as Maximum Sharpe, Minimum Variance, Equal Risk Contribution and Maximum Deconcentration – offer an alternative to the standard but troubled single period mean variance optimisation (“MVO”) approach. MVO’s limitations Single period MVO approach remains the traditional bedrock of very long-run investing in normal market conditions where the sequence of returns does not matter. However it runs into difficulty in the short-run when markets are non-normal and sequence of returns matters a lot. So unless you are a large endowment with an infinite time horizons, or perhaps can afford to invest for yourself and your family without ever needing to withdraw any capital, relying entirely on the MVO approach for asset allocation gives false comfort. For cases where there are constraints that challenge the MVO model - due to multiple or limited time horizons, expected capital withdrawals, risk budgets, and unstable risk/return/correlation profiles of asset classes (collectively known as real life) - portfolio construction requires a smarter, more adaptive approach that observes, isolates and captures the reward from shifting risk premia over time. Risk-based portfolio strategies attempt to achieve this and are designed to offer a liquid alternative approach to investing that is uncorrelated with traditional Single-Period MVO strategies. What’s the problem to solve? Whether assessing factor-based ETFs, or risk-based ETF strategies, at best these new developments seem all very smart. At worst it’s just a bit different. However, as ETFs get smarter and the strategies that combine them become more sophisticated, there’s a risk that the key question in all of this gets lost in an incomprehensible barrage of Greek. The key question for portfolio managers nonetheless remains the same. What client outcome am I targeting? What client need am I trying to solve? For portfolio strategy, whether using a discretionary manager that relies on judgement, or a systematic rules-based approach that relies on quantitative inputs, the key client considerations remain return objective, time horizon, capacity for loss, and diversification across asset classes and/or risk premia. Broadening the toolkit A portfolio strategy has little meaning without an objective that focuses on client outcomes. Factor-based ETFs and Risk-based ETF portfolio strategies offer an alternative or additional set of tools to help deliver on those outcomes, in a way that is systematic, liquid and efficient. It's hard not to get emotional when markets get difficult.
As with any temper-tantrum, having a clear rules-based approach can help maintain investment discipline when emotions run high. One of the attractions of a multi-asset Smart Beta approach is that portfolios can dynamically adapt to "reflect the pulse" of the markets following clearly defined, systematic rules. While this may be short on art, and long on science, compared to smart Alpha managers, the scientific approach also benefits from the certainty of much lower fees. Furthermore, a dynamic approach can help mitigate tail-risk. For anyone except those with an infinite time horizon (endowments), relying on a traditional single-period mean variance optimisation model for asset allocation strategy is problematic, because the long-run assumptions on which they rely do not necessarily hold for the short-run. And when it comes to managing tail-risk, the short-run matters. This is why our portfolio construction approach is outcome-oriented, aiming to create for example a Max Sharpe portfolio or Min Volatility out of a broad opportunity set of liquid, physical ETFs representing a broad range of asset classes and geographies. We've just past the 1-year live-pricing anniversary of the Elston Strategic Beta indices - the Global Max Sharpe strategy (Ticker ESBGMS) and Global Min Volatility (Ticker ESBGMV) strategy. For asset-owners looking at alternative ways to manage risk beyond a long/short 2&20 approach, low-cost risk-based multi-asset strategies are becoming a compelling alternative. |
ELSTON RESEARCHinsights inform solutions Categories
All
Archives
April 2024
|