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.
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.
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.
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.
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