AN ETF STREAM PUBLICATION // // Q1 … · strategist Andrew Lapthorne examines how diff erent factors (specifi cally value and quality) might react to changing ... Ed Bowsher Ed is

RobecoDo smart beta ETFs deliver on their factor promises?

Talis PutninsWhy ETFs may not be as passive as we all think

SGForget bonds, embrace value to stay defensive

ParalaInside The Black Box: Value indices deconstructed

AN ETF STREAM PUBLICATION // WWW.ETFSTREAM.COM // Q1 2019

BEY NDBETAINVESTIGATING THE SMART BETA, FACTOR & ESG INVESTMENT REVOLUTION

Doing The Right Thing?

Why ETF providers are falling over each other in the rush to create ESG (Environmental, Social and Governance) and SRI (Socially Responsible Investing) solutions

08 10 13 32

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In this issueUPDATES

4 New listings Our regular catch-up on the new smart beta ETFs listed from around the world over the last two quarters

6 The smartest beta Returns from ESG based ETFs put under the microscope by Scott Longley and George Geddes

PERSPECTIVES

8 Do smart beta ETFs deliver on their factor promises Asset management fi rm Robeco on why asset allocators are increasingly using factor premiums alongside traditional asset class risk premiums. Factor investing focuses on premiums that have been well-documented in the literature, like value, momentum and low-volatility premiums. But do the ETFs tracking these factors deliver on the promise?

10 Why ETFs may not be as passive as we all think Beyond Beta editor David Tuckwell recently caught up with Prof Talis Putnins. In a wide-ranging discussion, they focused on why ETFs are misconstrued as passive vehicles – echoing Vanguard founder Jack Bogle’s long standing argument that ETFs are more of a traders tool – and why active fund management still has a bright future, using ETFs!

13 Forget bonds, embrace value investing to stay defensive in volatile markets SG’s star quant strategist Andrew Lapthorne examines how diff erent factors (specifi cally value and quality) might react to changing macroeconomic conditions

FACTORS IN FOCUS

17 ESG focus: A fund selectors guide to sustainable investing London based advisory fi rm Sparrows Capital investigates the hot topic of the moment, sustainable investing and why ETF providers are falling over each other in the rush to create ESG (Environmental, Social and Governance) and SRI (Socially Responsible Investing) solutions

20 ESG Focus: The case for socially responsible investing Andrew Walsh of UBS ETFs maps out the expansion in passive Socially Responsible Investing (SRI) and explores what’s behind the step-up in interest in these funds?

24 It’s Only Ever Truly “Passive” on the Way Up The quantitative experts at asset management fi rm QMA investigate a more active approach to the Core and Satellite portfolio construction approach

CLOSING REMARKS

30 Factor Index Update Parala’s Steve Goldin returns with our regular deep dive into the major factor indices used by market leading ETFs

32 Inside The Black Box: Value indices deconstructed Steve Goldin from London based research fi rm Parala investigates just how sensitive leading US value indices are to changing macro-economic factors

About us

David StevensonDavid trained as a economist before

moving into fi nancial journalism where he has written about investing and

fi nance for many years. David is CEO and Editor in Chief of AltFiNews and is also a columnist for the Financial Times (the Adventurous Investor), Investment

Week and Money Week. David is an experienced media entrepreneur (he’s set up a number of online media companies focused on online TV and viral videos) and investment expert of retail repute.

David TuckwellDavid is an Australia-based journalist

who covers exchange traded funds and fi ntech. He formerly worked in the ETF

industry in London. In another life he was a top national Tetris player.

Scott LongleyScott has been a journalist since the early

noughties covering personal fi nance, sport and the gambling industry. He has

worked for a number of publications including Investor’s Week, Bloomberg

Money, Football First, eGaming Review and GamblingCompliance.com. He now writes for online and print titles across a

wide range of sectors.

Ed BowsherEd is a freelance fi nancial journalist and broadcaster. Until May 2017 he

presented a daily show for Share Radio, the fi nancial radio station. Before Share Radio, his jobs included Deputy Editor

of MoneyWeek and Editor of The Motley Fool UK. Ed has been an active private

investor since 1997.

ETFSTREAM.COM Q1 2019 BEYOND BETA 3

UPDATE CONTENTS

Expertise | Technology | Data

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COMMENT FROM THE EDITORS-IN-CHIEF

DECEMBER 2018

UPDATE

Welcome to the second edition of Beyond Beta, our regular deep dive into the world of smart beta, factor investing and quantitative fi nance. Our main focus here in Beyond Beta is to provide actionable ideas for fund, and more specifi cally ETF, selectors and professionals. That forces us to confront the big new trends within the passive space. Top of that list at the moment must be ESG investing, also known as sustainable investing. Call us old fashioned, but we regard this as a sub set of quantitative investing, requiring index developers to operate multiple screens to exclude the ‘bad’ stocks and include the ‘good’ stocks.

Whether it is a form of smart beta is questionable i.e does it provide ‘more’ than just ‘plain vanilla’ beta? A small number of academic studies have suggested that a focus on ethical, environmental or socially sustainable factors can help eliminate the ‘riskier’, bad stocks in a broad index and provide a focus on the ‘good’ corporates with a more sustainable long-term game plan.

But the desirability of an investment strategy shouldn’t only be answered by a focus on returns – other factors are relevant such as volatility, correlation benefi ts and concentration risks. Arguably, one might also question whether a moral take on the stockmarket ‘makes sense’ for all buyers of funds?

Surely the point with passive investing is to eliminate the risks of idiosyncratic stock selection and focus on buying as broad a basket of stocks as possible – in this strategy a ‘moral stockmarket’ doesn’t immediately seem relevant? To underline this point, we recently interviewed Burton Malkiel, the doyen of passive investing and author of passive primer A Random walk down Wall Street, and he certainly expressed real concerns about ESG investing. Here’s what he said to us in mid-November whilst discussing the risks of thematic investing – “I will tell you now that I am getting very worried about ESG thematic funds. Let me ask you a question, is Lockheed Martin a very bad company in the United States because it makes instruments that kill people or is it a good company because it makes a missile defence system that makes me feel more secure living in the United States. I fi nd this, you know, troublesome. I much prefer broad [non ESG] indices”.

Our other concern is slightly more pedestrian. How will ESG screens and strategies perform if we move into a more volatile market environment, otherwise known as a new market paradigm? It’s clear to all and sundry that we are slowly but steadily moving away from a generally bullish market to one that is slightly more skittish and concerned about rising rates.

In this new ‘normal’, many once successful factor-based strategies might fall over, fade away or generally become less eff ective – and others might prosper. As Andrew Lapthorne of investment bank SocGen argues on these pages, value might start to shine. Value might even start to outperform growth or quality and we might see a more active form of asset allocation emerge amongst fund selectors keen to minimise downside risk. This new form of portfolio construction might be more sensitive to the ebbs and fl ows of the macro-economic environment.

All of these ideas – and more – are discussed in this edition of Beyond Beta but notice our constant use of the word “might’ in the previous sentence. Our sense is that we are entering a new landscape for factor-based strategies which will test many consensus trades and arguably even generate new factors we haven’t even thought about. The numbers might start to tell a very diff erent tale within the next few years.David Stevenson and David TuckwellEditors-in-Chief, Beyond Beta

EditorialBeyond Beta is published by

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ETFSTREAM.COM4 BEYOND BETA Q1 2019

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UPDATE PERFORMANCE

TOP ETF PERFORMERS DATA AND COMMENTARY

UPDATE

The rise of environmental, social and governance (ESG) investing is has become a headline-grabbing trend when it comes to ETFs.

Investor preference for funds which are aligned with their beliefs on social responsibility concerns is clear from the data.

The most recent release from ETFGI shows that as of October ESG-based ETFs and ETPs have increased their assets under management (AUM) by nearly 26% globally to close on $22bn in the year-to-date compared with 2.5% for ETFs and ETPs generally. This data confi rms the trends visible from other research published in the summer on institutional investment trends.

The report from State Street Global Advisors in July showed that the vast majority of institutional investors – over 80% – believe that ESG fl ows will increase in the next fi ve years. Meanwhile a report from the CFA Institute showed that a large majority of its European

The rise of ESG investing

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members believed that ESG factors should be considered when making any investment decision while nearly half think that fi nancial regulators should legislate for ESG considerations to be an integral part of the legal fi duciary duty to investment management clients.

However, despite the popularity the market remains reasonably restricted in terms of indices, despite the move by MSCI recently in relation to a BlackRock iShares launch (see below).

RECENT TRENDSOne of the most high-profi le ESG moves in recent months came from BlackRock iShares which announced a six strong new ESG-based suite of funds in October. Importantly, BlackRock priced the funds at the same level as its core range. Meanwhile, rival Vanguard similarly released two UK-listed ESG funds in September which saw the company suggest that ESG-based ETFs can provide the core components of a portfolio for investors. Adding to the ESG bandwagon, Amundi also recently launched three equity-based ESG funds and two fi xed-income

ETFSTREAM.COM

TOP ETF PERFORMERS DATA AND COMMENTARY

UPDATE

6 BEYOND BETA Q1 2019

CUMULATIVE INDEX PERFORMANCE - NET RETURNS (EUR) (MAY 2012-NOV 2018)

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– MSCI Europe ESG Screened– MSCI Europe

– MSCI Emerging Markets IMI ESG Screened– MSCI Emerging Markets IMI

– MSCI World ESG Screened– MSCI World

177.53174.64

130.26128.03

200.84196.91

It’s easy to assume that because ESG indices – and thus ETF trackers – exclude many stocks, the index is thus likely to underperform compared to its benchmark. This isn’t necessarily the case, however

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SMART BETA UPDATE PERFORMANCE

Q1 2019 BEYOND BETA 7

The key debatesDespite the growth in ESG funds, technical debates still swirl around the screening overlays deployed by index fi rms. Industry consultants ETFGI recently pointed to a United Nations supported initiative which said that over half of ESG adopters believes that there is a lack of clarity over defi nitions. Many have called for more consistency, suggesting the index providers have a key role in ensuring that naming conventions are adhered to and not led marketing considerations. What do fund selectors who use ETFs think about these debates? Oliver Smith, IG Portfolios: “It’s easy to be cynical about some of the ‘me too’ ESG fund launches we have seen in recent years, some of which have been launched with rather questionable back-tests to enhance their marketability. However, overall the investment opportunity has broadened signifi cantly with products accessible across more niche areas, such as corporate bonds, meaning investors no longer need make too many compromises in pursuing an ESG tilt. ESG is defi nitely not a silver bullet for making better returns; high correlations with

market cap indices suggest investors will not perform markedly diff erently in the long run. You can still expect to pay more for having an ESG focus too, though the fee gap has narrowed.”James McManus, Nutmeg: “At Nutmeg, we’re using the term socially responsible investing (SRI). We believe this term fairly refl ects our customers’ interests in limiting exposure to companies that engage in controversial activities while increasing exposure to companies that lead their peers in social responsibility. We know that talking about values has the potential to trigger a broad spectrum of emotions for investors, because values are personal. And having such a broad range of over-simplifi ed labels can also trigger confusion, simply because of the sheer volume of diff erent terms used to describe the diff erent investment approaches. To us, investing with a socially responsible focus is investing in companies that do business in a fair and progressive way, over-weighting towards companies with strong sustainability profi les, while avoiding those that engage in controversial activities.”

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– MSCI World ESG Leaders– MSCI World

– MSCI USA ESG Leaders– MSCI USA

167.27167.82

336.05314.97

funds. The company explicitly noted the need to service a growing need for socially responsible investment solutions.

ESG RETURNS?It’s easy to assume that because ESG indices – and thus ETF trackers – exclude many stocks, the index is thus likely to underperform compared to its benchmark. This isn’t necessarily the case, however. An ESG screened index usually mirrors the performance of its parent index and can even produce greater returns at times. An example of this is one of iShares’ recently issued ESG products, the iShares MSCI USA ESG Screened UCITS ETF, which tracks the screened MSCI USA index.

The graph shows the ESG screened index replicates the returns closely of its benchmark and even produces greater return by one or two per cent by 2015. Returns have been almost identical, with very little tracking error from the benchmark (non ESG) index.

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Do smart beta ETFs deliver on their promised factor exposure?Asset management firm Robeco on why asset allocators are increasingly using factor premiums alongside traditional asset class risk premiums. Factor investing focuses on premiums that have been well-documented in the literature, like value, momentum and low-volatility premiums. But do the ETFs tracking these factors deliver on the promise?

A popular way to obtain exposure to factor premiums is smart beta indices and ETFs. At Robeco, we investigated how these indices and

ETFs can be used to gain factor exposure. As a starting point, we allocated strategically to value, momentum and low-volatility equity factor portfolios and, in addition, to two new factors in the Fama and French 5-factor model: profitability and investment. We took the value, momentum, profitability and investment portfolios directly from the online data library of Kenneth French. The low-volatility strategy is not provided by Kenneth French and therefore self-constructed, following a similar methodology. The portfolios were considered on a market capitalisation and equally weighted basis.

We found that a simple, equally weighted combination of value, momentum and low-volatility factor portfolios results in a Sharpe ratio of 0.49, versus 0.32 for the market cap-weighted portfolio. The Sharpe ratio can be improved further to 0.58 by using equally weighted instead of cap-weighted factor portfolios. By adding profitability and investment factor portfolios to the mix, these Sharpe ratios are not improved further, but information ratios do go up, i.e. market-relative performance improves.

As for the smart beta indices, we used the Russell 1000 Value index and the MSCI Value Weighted index for the value factor. For the momentum factor we took the MSCI Momentum index. For low-volatility we took the S&P Low Volatility index. Indices that specifically target the new profitability and investment factors are unavailable. In their place, we considered two indices that are quite popular in practice: the MSCI Quality index and the MSCI High Dividend index. For the market portfolio we use the standard index of MSCI.

RESULT: SMART BETA INDICES APPEAR TO OFFER LIMITED FACTOR EXPOSURETable 1 shows how cap-weighted factor portfolios are able to explain the return of smart beta indices, considering the maximum available data history for each index through December 2015. Unsurprisingly, most of the performance of the Russell 1000 Value index is attributable to the Value factor portfolio, but its exposure to this portfolio is only 36%. The remaining exposure is attributed to the market portfolio (23%), the Investment factor (21%) and the Low Volatility factor (20%). This implies that the Russell 1000 Value index is not very suitable for investors seeking pure and sizable exposure to the value factor. The MSCI Value Weighted index, which uses fundamental weightings, provides more pure value exposure, but again very little, as 60% of its exposure is attributed to the market portfolio.

Table 1 also shows that a substantial part (73%) of the performance of the MSCI Momentum index is attributable to the Momentum factor portfolio. The remaining weight goes to the market portfolio. The S&P Low Volatility loads heavily on the Low Volatility factor portfolio (71%), combined with a bit of value exposure. These figures suggest that the indices are quite suitable for obtaining momentum and low-volatility factor exposure, but do not offer maximum exposure to these factors.

NO SUITABLE INDEX FOR THE INVESTMENT FACTORThe MSCI Quality index loads heavily on the Profitability factor portfolio (76%). But it does not provide exposure to the other new Fama-French factor, Investment, which could be seen as another dimension of Quality. For investors specifically seeking exposure to the Investment factor, none of the smart beta indices considered here appear to be

ETFSTREAM.COM

Robeco is an international asset manager offering an extensive range of active investments, from equities to bonds. Research lies at the heart of everything we do, with a ‘pioneering but cautious’ approach that has been in our DNA since our foundation in Rotterdam in 1929. We believe strongly in sustainability investing, quantitative techniques and constant innovation. More information online at www.robeco.com/uk/about-us/


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The main finding of our research is that factor investing with popular smart beta indices is not as straightforward as one might think

very useful. Interestingly, the MSCI High Dividend index provides a huge (83%) exposure to the Low Volatility factor portfolio, and next to that some value exposure.

Although the MSCI High Dividend index outperforms its replicating portfolio of factor strategies with over 1% per annum, the outperformance is statistically insignificant, which implies that there is insufficient evidence for added value beyond classic low-volatility and value factor exposure. The performance of the other smart beta indices is also in line with their factor replication portfolios. The one exception is the S&P Low Volatility index, which shows an economically large (over 2% per annum) and statistically significant outperformance.

This outperformance disappears entirely though if we also include equally-weighted factor portfolios in the analysis, as shown in Table 2. In this case we found 84% exposure to the equally-weighted Low Volatility factor portfolio, plus another 8% exposure to the value-weighted Low Volatility factor portfolio, and a performance difference which is close to zero.

From Table 2 we can also conclude that most of the performance of the other smart beta indices is not attributable to equally weighted factor portfolios, since most of the weight still goes to the cap-weighted factor portfolios. As

equally-weighted factor portfolios show a better performance than cap-weighted ones, this suggests that smart beta indices may not unlock the full potential offered by factor premiums.

CONCLUSION: SMART BETA STRATEGIES MAY NOT BE OPTIMALThe main finding of our research is that factor investing with popular smart beta indices is not as straightforward as one might think. Smart beta strategies typically seem to target one particular academic factor, but it turns out that the amount of exposure they provide to that factor can differ a lot. Many smart beta strategies do not offer maximum factor exposure, but still contain a significant amount of market index exposure as well, or some unexpected exposures to other factors.

Smart beta indices may not unlock the full potential of factor premiums, because in most cases they seem to be exposed to cap-weighted factor strategies, while equally-weighted factor strategies are known to generate higher returns. Altogether, these results imply that smart beta indices may be used to harvest generic factor premiums, but also that it is crucial to properly understand the characteristics of these indices in order to obtain the desired amount of exposure to each particular factor, and the intended portfolio risk-return profile.

ETFSTREAM.COM

PERSPECTIVESROBECO


TABLE 1. RESULTS USING CAP-WEIGHTED FACTOR PORTFOLIOS

TABLE 2. RESULTS USING VALUE-WEIGHTED AND EQUALLY-WEIGHTED FACTOR PORTFOLIOS

Market Value Momentum Low Vol Profitability Investment Total Outp (ann) T-stat

Russel 100 Value 23% 36% 20% 1% 21% 102% -0.62% -1.49

MSCI Value Weighted 60% 29% 8% 6% 103% -0.08% -0.24

MSCI Momentum 25% 73% 1% 99% 0.08% 0.10

S&P Low Volatility 12% 71% 83% 2.28% 2.36

MSCI Quality 23% 76% 99% 0.14% 0.29

MSCI High Dividend 20% 83% 103% 1.08% 1.03

Market Value Momentum Low Vol Profitability Investment Total Outp (ann) T-stat

CW EW CW EW CW EW CW EW CW EWRussel 100 Value 24% 27% 5% 12% 13% 3% 17% 1% 103% 0.99% -2.52

MSCI Value Weighted 54% 20% 6% 13% 9% 102% 0.31% -0.96

MSCI Momentum 25% 73% 1% 99% 0.08% 0.10

S&P Low Volatility 8% 84% 92% -0.03% -0.05

MSCI Quality 23% 76% 99% 0.14% 0.29

MSCI High Dividend 12% 8% 83% 103% 0.84% 0.80

Source: MSCI, S&P, Russell, Kenneth French & Robeco

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When passive is not so passive – are most ETFs active by application?Beyond Beta editor David Tuckwell recently caught up with Prof Talis Putnins. In a wide-ranging discussion, they focused on why ETFs are misconstrued as passive vehicles – echoing Vanguard founder Jack Bogle’s long standing argument that ETFs are more of a traders tool – and why active fund management still has a bright future, using ETFs!

David Tuckwell: Your new study argues that almost 90% of US ETFs incorporate some kind of active management. This is a finding that may surprise a lot of people. How do indexes and ETFs let active management slip in? Stock selection rules? Weighting rules?Prof Talis Putnins: It’s not that most ETFs have an “active” manager in the traditional sense that is doing stock picking within the fund to try and beat a benchmark, although some do. Rather, many ETFs track increasingly specialized and niche indexes which allow an investor to get highly specialized exposures to narrow segments of the market, or specific factors. For example, there are ETFs which give an investor exposure to AI or robotics, ETFs that specialize in obesity-related stocks, ETFs tailored to Gen-Y, ETFs that give exposure to value/size/momentum factors, or factors such as low volatility, high dividend payers, and so on.

The “activeness” of ETFs plays out in two ways. The first is the design of the specialized indexes or rule-based algorithms that govern what goes into the ETF portfolio. In some cases those are active investment decisions. The second and perhaps more important way is how ETFs are used by investors. Most ETFs are not designed to be a complete portfolio for an investor, but rather, they are building blocks from which investors can create their own “active” portfolios in an efficient, low cost manner. For example, if I have a view that robotics, platinum, small caps, and value stocks will do particularly well, ETFs allow me to easily construct a low-cost portfolio that expresses those views and will beat the market if my views are correct. That is active investing, not passive.

ETFs could also be used for passive investing, and some are. For example, I could invest in one of the broad market ETFs that earns close to the market return. A passive investor would use the broad market ETFs, not the highly specialized niche ETFs. Our finding that most ETFs, whether measured by number, assets (AUM), or turnover, are “active” in the sense that they depart considerably from tracking a broad market index indicates that much of the activity in ETFs is active investing. The high turnover of ETFs – a characteristic of active investing – further supports this conclusion.

What this means is that the growth of ETFs does not necessarily reflect a shift to passive investing. Rather, it reflects a change in the way active investing is done. Instead of active investing through high-cost traditional mutual funds, many investors are choosing to actively invest through ETFs. And we are not just talking retail investors here – many institutional investors are finding ETFs useful to implement their active strategies and get exposure that corresponds to their views rather than using individual stocks.

Does this mean that smart beta ETFs are essentially cheap active management?This is how smart beta funds are viewed by some investors. Traditional active mutual funds do not have a good track record in terms of the returns they have delivered to investors. They generally underperform their benchmarks after fees. Some funds deliver strong returns by loading on various factors that earn return premiums, such as size, value, momentum, quality, illiquidity, low volatility, and so forth. Smart beta ETFs allow investors to efficiently gain exposure to those factors in a low

ETFSTREAM.COM

The growth of ETFs does not necessarily reflect a shift to passive investing. Rather, it reflects a change in the way active investing is done


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cost manner. Essentially, through smart beta ETFs investors can obtain whatever factor exposures they might want but bypassing the middle man - the high-cost fund manager.

There is another use of smart beta ETFs, in particular the single factor ones, and that is factor timing. While factors have in the past delivered return premiums, they go through cycles of performing well some times and poorly at other times. Factor timing involves rotating through factor exposures according to one’s view about which factors will perform well over the coming period. Doing so with single-factor ETFs rather than individual stocks can be easier and cheaper. There is evidence that institutional investors use single-factor ETFs in this manner, and do so successfully.

Another way that institutional investors use single-factor ETFs is to add a factor tilt or remove a factor tilt from an existing portfolio. Say a portfolio they construct is too heavily tilted to value and not enough to small caps. Single-factor ETFs provide an easy way to adjust those tilts to the desired exposures.

What’s the difference between a ‘moderately active’ and a ‘moderately passive’ ETF, as you define it?Simply the extent to which the ETF’s holdings

differ from the broad market index. An ETF in our “very passive” category holds a portfolio that is very similar to the value-weighted market portfolio. “Moderately passive” ETFs somewhat depart from the market portfolio, for example they might focus on large stocks, but are still fairly broad in their holdings. “Moderately active” ETFs are already narrow enough that we would not consider them passive investments. And finally, “Very active” ETFs are highly specialized and have concentrated holdings – they are used for specific bets on a group of stocks, a segment, or a narrow factor.

You also note that the proliferation of ETFs doesn’t necessarily mean that passive investing is getting more popular. Why do you think people find active management so appealing despite knowing that actively managed funds, on aggregate, must equal the market?My personal view is that many people, in particular those managing money, are not willing to accept an “average” outcome up front, which is what passive investing offers. Many people want to be better than average, which is what leads them to active investing. This is partly driven by overconfidence and over-optimism, leading to the belief of being able to beat

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PERSPECTIVESPROF TALIS PUTNINS


ETFs somewhat depart from the market portfolio, for example they might focus on large stocks, but are still fairly broad in their holdings

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ETFSTREAM.COM

the average. Many studies show that we think that we are better than we in fact are. Even though many investors recognize the basic arithmetic of investing, namely that the active investors as a group will earn close to the market return before fees, most believe that they are better than the average investor and therefore are likely to outperform others.

A further contributor is the lack of financial literacy among retail investors. Many are not aware of the evidence on active fund manager performance or the fact that fees are a strong predictor of the degree of long-run underperformance.

Do you think a better distinction than active vs. passive is judgement vs. rules-based?I don’t think so. I think there is still an important distinction to be made between active and passive. In making that distinction, we just have to be careful to not incorrectly attribute certain investments to passive that are actually forms of active investing, such as many of the ETFs that exist today, particularly if they are used in an active way to make bets in the market. Judgement and rules-based can both be forms of active investment. When it comes to ETFs, the two are often used together. For example, it is common to apply judgement to pick the rule-based vehicles that one believes will outperform. This is how ETFs are used in active investing.

If ETFs lower the costs of active management, does that raise the chances of beating the index? After all, a big part of the reason active managers lose to passive is their fees. I think it certainly raises the chances that the ultimate end investors will walk away with better investment outcomes – higher long-term returns, not necessarily because they are beating the market through active investment decisions, but simply because they will lose less of their wealth in fees.

I don’t think that having lower cost investment vehicles such as ETFs will necessarily make it easier to beat the market – as it becomes cheaper for active investors to implement their strategies through ETFs, we could see more active investing, ultimately making the market more efficient. There is some evidence to that effect. In other words, the efficiency of ETFs as a means of implementing active strategies could have a flow on effect and make the market more efficient overall. ETFs can also help markets become more efficient by relaxing some of the constraints or frictions that exist in markets. For example, through their stock lending activities, ETFs relax short selling constraints in hard-to-short stocks, which can help correct mispricing

in such stocks. ETFs are also useful for hedging. For example, by shorting an industry ETF industry risk can be hedged while taking an active position in an individual stock.

This is not to say that there aren’t any distortions created by ETFs. In particular, as some ETFs become very large, they carry a lot of weight in the market and large flows in or out of these funds, or rebalancing events, could potentially have significant price effects.

You dismiss the idea of ETFs being parasitic on active managers price discovery. Could you please walk us through the evidence for why you think this is a myth?To the extent that ETFs are used in implementing active investment strategies, or as building blocks for active investment portfolios, they are likely to play a role in price discovery. Thus, ETFs do not merely feed on the price discovery of others, but they help bring information to the market. Studies provide evidence of this.

I think the comments about parasitic behavior are directed to passive investing – ETFs only get wound up in these arguments because many people incorrectly label ETFs as a whole as passive investing. If a passive investor simply invests in a broad market index without regard for absolute or relative valuations and does so in a low-cost manner without making losses to active investors, then they don’t contribute to price discovery. Active investors drive price discovery.

Does this make passive investors parasitic? I don’t think so. For them to be parasitic implies that in relying on the price discovery provided by active investors, passive investors harm active investors, which I don’t think is the case. It seems to me this claim of parasitic behavior has been put forward by traditional active fund managers that have suffered large outflows of funds in the past decade. Those outflows, largely going to low-cost vehicles such as ETFs and index funds, mean traditional active managers make less in fees. That is where traditional managers are perceiving harm. But think for a moment who is feeding on whom? Traditional active managers feed on their investors by charging them relatively large fees. Not only do traditional active fund managers rely on these fees to survive like a parasite relies on its host, but the fees also harm the long-run performance of investors, much like a parasite harms its host organism. Fees are one of the strongest predictors of underperformance. So, if anything, the parasitic relationship is between high-fee fund managers and their investors.

To the extent that ETFs are used in implementing active investment strategies, or as building blocks for active investment portfolios, they are likely to play a role in price discovery

HISTORIESPROF TALIS PUTNINS

Talis Putnins is a professor of finance at the University of Technology, Sydney. One of Australia’s top experts on asset pricing, he recently published one of the foremost studies of the US ETF industry. The study, which he co-authored with several academics at Cornell University, argues that the vast majority of ETFs are actively managed, and rather than undermining active management, ETFs are making it grow.


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Worried about bond selloffs and bond/equity correlation – is Value the solution?Forget bonds, embrace value investing to stay defensive in volatile markets. SG’s star quant strategist Andrew Lapthorne examines how value and quality might react to changing macroeconomic conditions

Factor based strategies have increased in popularity in recent years but how will varying styles such as value and quality react to a changing macro-

economic situation – with interest rates rising in much of the developed world? Might value stocks prove to be a useful replacement for bonds?

What are Value stocks, why do they outperform or even do they outperform is a seemingly endless topic in the financial literature. Indeed, here I am still writing about the damn subject having done so for the best part of the last two decades. Surely things should have been settled by now! But alas no…

For me, as a quant, Value as with most quantitative factors is simply a classification system, much like a country or sector index. Yes, I’d dearly like to think I’m following in the footsteps of the great value investors (Benjamin Graham will typically appear in most Smart Beta literature) but alas I’m not. I simply don’t have the time or indeed most probably the expertise to fundamentally analyse thousands of stocks to see if the odd one or two are worth an investment.

No, for me, Value, when expressed in terms of an index or portfolio built solely based on valuation criteria is a portfolio of distress, an index that seeks to fill itself with the world’s problems, a list of stocks that usually inspires a degree of revulsion when the constituent names are read out. And it is for these reasons and these reasons alone we like Value, for distress has a price, distress has a purpose and buying distress when it’s very cheap is usually a great way to make money. If you can keep your job in the meantime…

The inverse asset to distress is the risk-free rate, the clue is in the name (rebuttals on a postcard please), and as such it should make sense that in a diversified asset allocation, Value should be a good hedge to rising bonds yield and we’d argue the post central banks interventions and quantitative easing it is perhaps the better hedge to rising bond yields, than equity markets overall.

Type bond/equity correlation or Fed model into Google and you’ll not be short of opinions on the directional relationship between equity and bond market. It is inherently unstable,

PERSPECTIVESANDREW LAPTHORNE


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particularly during a crisis. Sector/bond correlations are even worse. Pity the poor Communications sector, high beta, exciting and dangerous in 1999 to become a boring dividend yielding bond proxy in 2018, only to be redefi ned and rammed full of yet more exciting tech stocks in September 2018. The historical price time series is essentially worthless, it has no meaning, defi nitionally it is too volatile.

The telecoms/communications sector is an extreme example of some of defi nitional problems we face in the equity market (note, bond markets are already largely defi ned on a quantitative basis). But the same can be said of equity markets themselves. We have been living through extraordinary times, a time when global equity markets have not been driven by profi t growth, as is usual for bull markets, but through valuation change as investor re-rated equities on the back of lower bond yields and in a chase for yield.

As such the re-rating of equities on the back of these aggressive central bank policies has not fallen uniformly. Higher Quality stocks defi ned as profi table and growing companies with stronger balance have seen the best of the re-rating as investors swapped safe bonds for the safest equity they could lay their hands on. The same could be said of the popular Low Volatility factor.

Value stocks on the other hand have remained unloved, often refl ecting the problems quantitative easing was trying to solve or suff ering as a direct consequence (think banks and the interest rate curve). The relative valuation change has been dramatic, inverse correlation notable and the impact on today’s equity market indices and therefore the infl uence on the future bond/equity correlation is a major concern.

In many ways the idea of targeting specifi c risk-premia as an alternative to traditional asset classes came into prominence in the aftermath of the fi nancial crisis when investors lost money on both their bond and equity portfolios. With bonds under pressure from QE withdrawal and equities indices expensive or over-exposed to “bond proxies” those same diversifi cation concerns are all too real today. We would argue that by defi ning equity markets by their quantitative characteristic helps that purpose. They are not asset classes in themselves, but a lens in which to view and analyze the market. Is the Communications sector bond sensitive? Who knows… is the Quality factor? Yes, absolutely.

When we analyze the historical performance of factors, we are subjected to the prevailing historical environment. Back-test most things in Japan over the last 30 years and you’ll be faced with a massive and prolonged bear market in equities (every wonder why there is so little written about factor performance in Japan!).

BOND TAIL RISKBelow we look at the sensitivity of each of the VALUE and QUALITY factors to changes in bond prices. So, to be clear, we are ranking daily US

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ROLLING FIVE-YEAR CONTRIBUTION OF VALUATION AND EPS GROWTH TO MSCI WORLD

VALUATION POLARIZATION – GLOBAL VALUE VERSUS GLOBAL QUALITY MEDIAN FORWARD PE

Source: SG Cross Asset Research/Equity Quant, MSCI

Source: SG Cross Asset Research/Equity Quant

Dividend YieldDividend YieldValuation ChangeEPS ChangeTotal Return

Quality

Value

The idea of targeting specifi c risk-premia as an alternative to traditional asset classes came into prominence in the aftermath of the fi nancial crisis when investors lost money on both their bond and equity portfolios

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■Dividend Yield ■Valuation Change ■ EPS Change■ Total Return


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CORRELATION OF US STOCKS TO US TREASURIES (10 YEAR)

LOW VOL EQUITY PERFORMANCE, 1990-2016

DAILY LONG-ONLY PERFORMANCE OF THE GLOBAL VALUE FACTOR VERSUS RANKED DAILY PERFORMANCE IN 10YR US BONDS SINCE 2010

CORRELATION OF EUROPEAN STOCKS TO GERMAN BUNDS (10 YEAR)

MULTI-FACTOR EQUITY PERFORMANCE, 1990-2016

DAILY LONG-ONLY PERFORMANCE OF THE GLOBAL VALUE FACTOR VERSUS RANKED DAILY PERFORMANCE IN 10YR US BONDS SINCE MID-2016


Source: SG Cross Asset Research/Equity Quant, Factset



Value PortfolioLow Volatility Por tfolioMSCI Europe

R² = 0.9253

R² = 0.9013

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Ranked change in 10 year UST (10 = biggest declines)

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201816141210

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■ Actual■ Immunised to Rates■ Falling Rates Eff ect

■ Actual■ Immunised to Rates■ Falling Rates Eff ect

■ Value Portfolio■ Low Volatility Portfolio■ S&P 500

Value PortfolioValue PortfolioLow Volatility Por tfolioS&P 500

■ Value Portfolio■ Low Volatility Portfolio■ S&P 500


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10-year Treasury in deciles and then measuring the coincident performance of each factor. We do this from 2010 onwards (longer-term the answer is the same) and then separately from mid-2016 onwards, when yields bottomed out and started the rise towards 3%. That means that decile 10 is when bond yields are rising most rapidly and decile 1 is when they are falling fastest. And as we show below, not only has the Value factor exhibited a very strong negative correlation to bonds, but that correlation has remained consistent since bond yields bottomed out and began rising from mid-2016 onwards.

Now, when we run the same exercise for the global quality factor, we see a signifi cant change in the relationship. Over the full period from 2010 onwards, Quality has a negative correlation with bonds. Remember, these are long only returns and therefore as equities generally have a negative correlation to bonds, it is picking up this overall equity eff ect. However, since mid-2016 not only has the correlation broken down somewhat, but in decile 10 when bonds are having the worst of days, the correlation between Quality and bond fl ips round.

This leaves Quality stocks in a potentially precarious position. When bond yields are falling rapidly, higher quality stocks may be outperforming on a relative basis, but on a long-only basis as equity markets tend to decline during these periods, quality stocks still lose money. More recently when bond yields are rising rapidly (i.e. decile 10) which is normally symptomatic of better than expected economic growth or higher infl ation, these quality stocks also lose money.

In brief, currently extreme upside or downside moves in bond prices, usually implies quality stocks lose money!

PORTFOLIO IMPLICATIONSThe staple of many retirement funds, the traditional core asset allocation portfolio, aims to gain participation in the upside of equity associated with economic fortunes while smoothing out the cyclical swings through relatively safe bond holdings. While the rationale of the equity sleeve is exposure to economic cyclicality, in practice it is implemented as holdings of cap-weighted equity-market indices that naturally tend to be dominated by high-quality, defensive type fi rms – i.e., bond proxies. Thus, one can argue that the traditional 60/40 portfolio might be more conservative and less cyclical than it ought to be as it double-counts counter-cyclical bond-like equity in the equity bucket. This would appear to be very much the case today.

The Value style is the most economically sensitive pro-cyclical equity strategy that allows investors to participate in the fortunes of economic growth with the attendant boom/bust cycles. On its own, it represents a signifi cant challenge to an investor of moderate investment-horizon, generating a maximum drawdown of more than 60 percent and volatility of 20%. However, as a source of exposure to economic cycles, the Value strategy appears to be a better choice in the traditional 60/40 portfolio than a cap-weight index benchmark. Substituting global value for cap-weighted equity in the 60% equity sleeve potentially improves absolute and risk-adjusted returns signifi cantly, without notably worsening drawdowns.

ETFSTREAM.COM


Andrew Lapthornejoined Société Générale in London in November 2007 and heads up the Quantitative Analysis team. Andrew spent 11 years at Dresdner Kleinwort, beginning as Quant analyst in 1996. Prior to moving to Société Générale, he was Global Head of Quantitative Research. The team has created and runs a variety of systematic quantitative strategies, the most popular of being the Global and European Quality Income Strategies. His team were ranked #1 in the last Extel survey and he was also ranked #1 as individual analyst for the last six years.

DAILY LONG-ONLY PERFORMANCE OF THE GLOBAL VALUE FACTOR VERSUS RANKED DAILY PERFORMANCE IN 10YR US BONDS SINCE 2010

DAILY LONG-ONLY PERFORMANCE OF THE GLOBAL VALUE FACTOR VERSUS RANKED DAILY PERFORMANCE IN 10YR US BONDS SINCE MID-2016


R² = 0.8854

R² = 0.1647

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)

Ranked change in 10 year UST (10 = biggest declines) Ranked change in 10 year UST (10 = biggest declines)

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BB_1218_FINAL.indd 16 25/01/2019 08:39

A guide to sustainable investing using ETFsLondon based advisory firm Sparrows Capital investigates the hot topic of the moment, sustainable investing, and why ETF providers are falling over each other in the rush to create ESG (Environmental, Social and Governance) and SRI (Socially Responsible Investing) solutions

Sustainable investing is the topic of the moment, with ETF providers falling over each other in the rush to create ESG (Environmental, Social and Governance)

and SRI (Socially Responsible Investing) solutions to meet perceived investor demand. Nevertheless, there remains much confusion around the subject, stemming from a lack of standardisation and a proliferation of semi-technical terms addressing nuances of philosophy and approach.

The core concept behind this investment strategy is that a responsibly managed company will be a more robust business that contributes towards sustaining the environment and the health of society and by nature of this contribution becomes a sustainable business in its own right. Sustainable investing is a developing discipline and the concepts, processes and products will continue to evolve over the coming years.

The approach involves adjusting investment behaviour in relation to such matters as honesty and ethics in business, air and water quality, and the evolving interaction between labour, land and capital. Clients increasingly want their money not just to generate a return but are also looking to “do well by doing good”. It is useful to think of sustainable investing as a spectrum, with one end bounded by traditional financial investment filters, and the other bounded by philanthropy.

ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) CRITERIAESG considerations look beyond the usual financial and macroeconomic drivers reviewed by analysts by adding specific assessment criteria focussing on long-term ESG risks and management’s response to them. Environmental screening focuses on the impact a company’s activities may have on the environment or on climate change, and similarly on the impact environmental developments may have on that company’s future. An example might be an analysis of

expected changes in government regulations (Clean Air Act) or tax regimes (carbon tax) for a company involved in a polluting industry.

Social screening addresses societal matters such as inequity, diversity, and human rights. workplace health and safety record. Examples might include the (positive) provision of schooling and healthcare for communities involved in major projects, or the (negative) impact on staff morale of a poor diversity culture. Governance factors relate to the quality of managerial and board level leadership, and include such items as strategic vision, board composition, independence and leadership, succession planning and remuneration.

ESG scoring addresses a framework of qualitative risks. The discipline attempts to identify and penalise unaddressed risks, but also to reward businesses that are less exposed to, or in a position to benefit from, ESG risks. The primary intention of a pure ESG screen is to improve the risk return profile of a portfolio. This process tends to favour socially responsible companies, but it is important to recognise that such an emphasis is a by-product of the process rather than a primary aim. An ESG scoring approach does not specifically look to exclude or include specific companies or industries, and an ESG weighted portfolio may therefore contain exposure to industries deemed undesirable by some investors unless further screens are applied.

Any assessment of qualitative risks is by nature subjective. The use of third-party agencies to perform scoring and ranking functions goes some way to address this, but investors should be aware that any measure of non-financial risk introduces human judgement into the investment process. Rule-based does not necessarily mean objective.

SOCIALLY RESPONSIBLE INVESTING (SRI)SRI investment applies a more aggressive filter, taking into account the behaviour of potential investee companies and the power of capital to influence

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Sparrows Capital is private investment firm servicing family offices, wealthy individuals and selected institutions Dr Raymond Backreedy was originally a founding partner at Evolutionary Trading and Tekio Capital. Most recently Raymond acted as consultant to the executive committee and board of trustees of a large Dutch pension fund, where he was involved in quantifying the impact of regulatory changes on their investment processes. Raymond has a PhD and MEng from the University of Leeds in Fuel and Energy Engineering. Mark Northway has previously worked for LBBW, Rabobank and Standard Chartered Bank, and chairs ShareSoc (The UK Individual Shareholders Society).


FACTORS IN FOCUSSPARROWS CAPITAL

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TABLE 1: THE SUSTAINABILITY CONTINUUM

business. The intention is to skew the portfolio toward responsible businesses and to avoid socially irresponsible or unethical activities. Adherents believe that socially responsible selection will positively infl uence investee companies’ performance over time while helping to preserve and enhance the world in which they operate.

An SRI portfolio may employ ESG criteria as an underlying framework for analysing companies, but takes a more prescriptive, values-based approach. It will specifi cally exclude sectors, industries and companies associated with activities deemed undesirable. The expectation of a premium return for SRI relies on the premise that less responsible “vice” companies will suff er over time from withdrawal of capital, from regulatory restrictions and / or from legal action, reducing shareholder returns and in some cases resulting in the demise of the company. The evidence surrounding this premise is complex, and the actual outcome of SRI investing will depend heavily on the specifi c policies adopted. An SRI fi lter can reduce the investible universe substantially, resulting in signifi cant portfolio concentrations and deviations relative to the capitalisation-weighted market.

IMPACT INVESTINGA more radical approach to ensuring positive societal outcomes is impact investing. The primary focus of this discipline is on achieving specifi c positive impact through investing. A positive return on investment is targeted, but fi nancial outcomes are generally subordinated to the portfolio’s impact objectives. Performance measures and reporting will take account of and measure both social and fi nancial outcomes. Many active impact funds now

measure themselves against the UN’s Sustainable Development Goals (SDGs) promulgated in 2015.

There is a wide spread of fi nancial expectations in the impact investing sector. Approximately two thirds of investors target market equivalent returns, with the remainder actively accepting below-market performance. Examples of impact investing include emerging market microfi nance activities, developmental agricultural funds and certain social infrastructure and healthcare funds. Impact investing may be particularly suited to charities and endowments who wish to ensure that their investment activities are actively aligned with their charitable objectives. Relative to ESG and SRI portfolios, an impact portfolio will result in further substantial restriction of the investible universe, into companies and activities somewhat less focussed on fi nancial outcomes. Investors should expect increased associated tracking error and underperformance.

STEWARDSHIPThe single most common strategy in in the UK for implementing an SRI strategy is voting and engagement – active stewardship involving dialogue with both investee companies and with fellow investors. Stewardship sits alongside ESG criteria and requires signifi cant organisational resource and commitment. Asset managers address their stewardship responsibilities in diff erent ways. At one end of the scale, some providers pay lip service to the issue, and simply delegate the function to proxy voting services such as ISS. At the other end of the scale, some managers invest heavily in standalone governance and stewardship capabilities and take their fi duciary responsibilities very seriously. ETF providers are generally focussed on cost reduction and will tend to address stewardship through proxy services. Exceptions include Blackrock, who have made a conscious investment in improving their performance in this area. The larger providers, particularly those that span the full active and passive universe, are best placed to address stewardship due to their combined economies of scale.

FACTOR OR FILTERSustainable investing is a relatively new trend, and there is therefore only a limited performance data set available; as a result, very few serious academic studies have been published so far. There is plenty of marketing material in circulation associating ESG and SRI approaches with outperformance relative to the market. Investors should approach such claims with caution, since the analysis may be subject to commercial bias and is heavily infl uenced by the fl ow of capital into sustainable assets over recent years.

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A more radical approach to ensuring positive societal outcomes is impact investing. The primary focus of this discipline is on achieving specifi c positive impact through investing

Traditional Return-focused

Investing

SociallyResponsible

Investing

PhilanthropyImpact Investing

ESG Integration

Broad market Sustainable Ethical


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Regulatory intervention may increase the flow of capital into sustainable assets in the shorter term. The European Commission has adopted a package of measures announced in its action plan on sustainable finance, with a view to aligning financial flows with the UN 2030 Agenda and Sustainable Development Goals . This builds on the good work of the UNPRI, an association of institutional investors who have signed up to a set of principles launched by the UN in 2006. These principles require the incorporation of ESG principles into analysis, decision-making and stewardship processes. Once such flows stabilise, non-ESG shares will sit at an effective discount to the broader market and will provide higher returns in order to attract capital. Historical analysis suggests that ‘vice’ stocks have outperformed over the long term.

More data is needed, together with more robust academic analysis in order to develop a clearer picture of the effect of restricting the investible universe via ESG and / or SRI mechanisms. In the meantime, investors should prudently take the approach that these approaches behave more as filters than as factors, and that a move from left to right along the spectrum shown at Table 1 is likely to be accompanied by increased portfolio concentration, a bias toward large cap stocks, increased tracking

error and reduced long-term portfolio performance. Responsible investors are likely to take the view that such a trade-off is worthwhile.

CONCLUSIONSustainable investing remains a fledgling discipline but one that is rapidly gaining traction, supported and encouraged by governments and non-governmental organisations (NGOs). Europe leads the world in terms of implementation. It is now possible to produce an efficient, screened, sustainable ETF portfolio; however, as with all investing, the design process is simple in concept but complex in execution.

The key portfolio approach within the UK is the exclusion of undesirable sectors and / or companies, usually across the top of an ESG weighted approach. Unsurprisingly, the ETF offerings available to European investors reflect this methodology.

The application of SRI to ETFs presents challenges, but some providers have satisfactorily addressed these. The range of instruments available is currently quite restricted, but new listings are now being announced on a regular basis. A product provider’s approach to stewardship, and commitment to integrating ESG considerations into that approach, should be critical to any investor’s screening process.

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FACTORS IN FOCUSSPARROWS CAPITAL

Practical Issues ESG RATING AGENCIESThe market is awash with ESG rating and information provider agencies and with sustainability indices. Most international and domestic public (and many private) companies are evaluated and rated on their ESG performance by various third-party providers of reports and ratings. A recent paper presents an exhaustive overview of the different criteria for evaluation used by ESG agencies. The results suggest that the methods currently being used by agencies remain inconsistent and demonstrate a lack of standardisation.

DEFINITIONAL DIFFERENCES AND DATA CHALLENGESThe definition of socially responsible activity is highly subjective and varies by rating organisation and by investor. Index providers use inconsistent proprietary definitions, and the weightings of ESG ETFs can vary substantially. Even those indices that rely on the same criteria, such as a MSCI ESG rating, may apply it differently. As a result, some ETFs will invest across the full spectrum applying an ESG weighting, while others will not invest below a defined minimum threshold score. Industries excluded by most SRI indices include alcohol, tobacco, gambling, armaments, adult entertainment and nuclear power. There is considerable inconsistency in the treatment of fossil fuels. Certain indices define a fossil fuel company as one that holds fossil fuel reserves, others only exclude those that produce ‘more carbon-intensive fossil

fuels’, while others exclude companies with a ‘significant interest in’ fossil fuels. Fixed income also provides significant data collection challenges. Bonds may not be subject to the same disclosure requirements as listed equities.

INDEX CONSTRUCTIONIndex construction relies on scoring processes carried out by ESG rating agencies. Criteria, relevance and weightings are very subjective and vary between agencies, which can result in unexpected outcomes at times. There are three principal types of sustainability index:Broad sustainability (ESG) indices – created top-down by filtering a conventional market index through broad-based sustainability (often ‘best-in-class’) screens. These may include the whole market adjusted to take account of ESG rating or may exclude shares with an ESG rating below a predefined percentile.Ethical exclusion (SRI) indices - these screen out companies exposed to ‘undesirable’ industries and business activities or companies that contravene religious principles. This screen is usually applied in addition to an ESG bias or filter.Specialist thematic indices – constructed from bottom-up by identifying stocks positively exposed to specific beneficial activities. Renewable and clean tech indices are common as inclusion criteria; climate change indices are also becoming more evident.


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The case for Socially Responsible Investing ETFsPassive Socially Responsible Investing (SRI) has seen a major increase in significance recently. Since April 2014, assets in these products have increased more than twelve-fold to total £2.85bn as of end August 2018. So, what’s behind the step-up in interest in these funds? Andrew Walsh of UBS ETFs maps out the expansion in passive SRI

Historically, investors who wanted to invest with a good conscience had to do so in one of two ways. The first was by carefully choosing their own

portfolios which steered clear of the likes of tobacco stocks and weapons manufacturers and focused on stocks which were deemed to be more proactive in following Environmental Social and Governance (ESG) principals. The other alternative of course was to seek out actively managed SRI funds which would take care of the groundwork for ethically-minded investors.

It’s also worth pointing out that there was a prevalent view that presupposed that investing ethically went hand in hand with underperforming the market due to a lack of solid performing so-called ‘sin’ stocks.

Views however have changed, and this has had a direct impact on the inflows into SRI ETFs. First, investors are increasingly aware of the fact that they can gain access to SRI via passive funds such as ETFs which provide simple, transparent and cost efficient access. As an example, the UBS MSCI World Socially Responsible ETF trades on the LSE just like a single stock and now has a TER of 0.25% per annum which compares quite favourably to an actively managed alternative. Based on a rules-based ESG scoring approach, investors gain access to a screened SRI portfolio which is made up of the c. top 25% ESG compatible constituents of the MSCI World index with sector weights across the key 11 ‘GICS’ (Global Industry Classification Sectors) sectors.

In addition, there has been an increasing amount of academic evidence which shows that the SRI screening process does not create a hindrance to performance against their standard ‘plain vanilla’ benchmarks. In fact, what has been quite an eye opener for many investors is that many of these SRI indices (and the ETFs which track them) have

actually delivered better performance on a risk adjusted basis to their standard parent benchmarks over the long term.

ENVIRONMENTAL, SOCIAL AND GOVERNANCE – THE THREE PILLARSAs we know, the world of SRI investing has boomed over the past few years with more and more investors switching on to the possibilities of not just investing their money but trying to do some good with it too. What can often get lost in translation is what we mean by SRI and what it entails.

At UBS, this means broadening out the investment analysis to consider the three key pillars of environmental, social and governance (ESG) issues. Not only does it provide a broader view of the potential upside and downside of an investment, it provides a vital level of transparency for investors that helps inform better decision making.

HOW DO WE DEFINE ESG?• Environmental: issues connected to climate

change, greenhouse gas (GHG) emissions, energy usage, waste and pollution, use of renewables and other such issues.

• Social: issues connected to working conditions, including human rights, child labour, local communities, health and safety and access to healthcare amongst others.

• Governance: concerns about overall business ethics, executive board structure and independence, bribery and corruption, remuneration policies etc. The three ESG pillars are fundamentally different.

The environmental issues are more industry-specific and reflect how a company’s activities deal with the individual risks they face. The social issues dealing with human rights are considerably more region-specific and they largely mirror the strength of

ETFSTREAM.COM

Andrew Walsh is Head of Passive and ETF specialist sales for the UK and Ireland at UBS. UBS offers a broad range of physically and synthetically replicated ETFs and is currently the fourth largest provider of ETFs in Europe and top provider of SRI solutions. Overall the firm offers 230 ETFs.


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institutional legal frameworks such as watchdogs and regulators across different jurisdictions. Finally, the governance factors are actually more company-specific and can be seen as a proxy for the quality of a company’s management.

Combining all three ESG pillars can provide a more holistic view on how a company deals with the broad set of risks that businesses face. Viewing the three metrics as one overall single measure makes sense in a world which is becoming increasingly globalized and where companies operate across multiple countries and jurisdictions as a matter of course. Many sustainable investors and investment solutions already employ this. It is also important to understand which pillar most determines a company’s performance and is more relevant for overall portfolio performance. For example, governance metrics may prove more relevant from a risk perspective when compared to social issues.

MSCI ESG RATINGSThe underlying framework for UBS’s SRI ETFs relies on MSCI’s screening framework. In brief, the MSCI ESG Ratings is the core part of the screening process used for the MSCI SRI indices and the UBS SRI ETFs which track them. This can be formulated around four questions:

• What are the most significant ESG risks and opportunities facing a company and its industry peers?

• How exposed is the company to those key risks and/or opportunities?

• How well is the company managing key risks and opportunities?

• What is the overall picture for the company and how does it compare to its global industry peers? Within the MSCI ESG Ratings, companies are

assigned an ESG rating scaled as such: AAA, AA, A, BBB, BB, B, CCC, and Not-Rated. This scale reflects companies’ performance relative to standards and performance of industry peers. A rating of AAA represents the best-in-class in terms of dealing with ESG risks/opportunities compared to industry peers, whilst CCC indicates the opposite. The industry-relative assessment has a strong logic; the companies need to be evaluated towards a similar set of ESG risks/opportunities. For example, energy companies will be more prominently assessed towards environmental issues, whereas financial companies towards governance ones. The final ESG rating letter is derived as the weighted average of the ESG Key Issue Scores which are done across industry peers.

In MSCI’s ESG ratings process, companies are monitored on a systematic and ongoing basis,

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FACTORS IN FOCUSANDREW WALSH


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Specifics on MSCI’s SRI screening methodologyThe MSCI SRI methodology uses a three-pronged approach. • Part 1: Negative Screening. • Part 2: ESG Ratings combined with a • Part 3: Controversies Scores.

The process acts to bring the list of companies down to c. 25% of the parent index to create what is in effect an ‘all-star team’ of the companies with the strongest ESG profiles. PART 1: NEGATIVE SCREENING:Negative screening (aka Business Involvement Screening) means the exclusion of the so-called ‘sin stocks’. These relate to: Alcohol, Gambling, Tobacco, Military Weapons, Civilian Firearms, Nuclear Power, Adult Entertainment and Genetically Modified Organisms. Depending on the geographic region, Negative Screening could remove anywhere from c. 3%-10% of the ‘parent’ index upon which the SRI index is built. So, if the parent index has c. 600 stocks in it, one could expect to see roughly between 20-60 stocks removed as result of this part of the screening process. PART 2: ESG RATINGS - INTANGIBLE VALUE ASSESSMENT (IVA)This is the first part of the positive screening process which goes about

ranking the whole list of underlying companies within the parent index based on a host of ESG-related metrics. MSCI has c. 250 dedicated analysts focused on in-depth research on this area. The ESG IVA screen involves 37 specific metrics including: Carbon Emissions, Water Stress, Energy Efficiency, Renewable Energy Usage, Labour Management, Health & Safety, Business Ethics, Corruption & Instability etc… As previously laid out, the scoring has seven bands: AAA, AA, A, BBB, BB, B, CCC. PART 3: ESG CONTROVERSIES SCOREThis part provides assessments of controversies relating to Environmental, Social and Governance impact caused by their business practices. The Metrics aim to penalise companies which have specific extreme controversies such as those committed by Facebook, BP, VW and Exxon to name just a small number. These are designed to be consistent with international norms represented in numerous widely accepted global conventions, including the Universal Declaration of Human Rights, the ILO Declaration on Fundamental Principles and Rights at Work, and the UN Global Compact.

The scoring here is based on 0-10 measured across 28 specific indicators. The lowest controversies score is the company’s controversy score. That is; even if a company has 10/10 scores across all other metrics but receives a 0/10 for a single metric (e.g. due to an extreme failure in e.g., bribery and fraud), that company’s Controversies score is 0/10 and thus would be removed from the SRI index at the next review. EJECTIONS AND ADDITIONS INTO THE MSCI SRI INDICES• Existing companies need to maintain an

ESG IVA rating of BB and above to stay in the SRI index.

• Existing companies need to maintain an ESG Controversies score of 1 or above to stay in.

• New entrants are eligible to be included if their ESG rating is A or above.

• New entrants are eligible to be included if their Controversies score is 4 or above.

• Importantly, simply having an ‘A’ and a 4/10 does not necessarily mean a company will be included if a sector already has sufficient number of constituents which meet the inclusion criteria. This is to ensure that turnover is kept at a minimal level.

including daily monitoring of controversies and governance events. In principle, companies have an ESG rating review at least annually. Arrival of new information is however reflected in reports on a weekly basis and substantial score changes may subsequently trigger a rating change outside of the annual review cycle.

SECTOR NEUTRALITYA feature with the MSCI SRI indices is that they are designed to target sector neutrality. That is to say, the indices are meant to act as proxies to the standard parent indices so that investors accessing these know that they will be getting comparable exposure and weights across the key 11 GICS sectors – similar to that of the parent index.

To be clear, these indices are not designed to exclude all of say, the Energy sector or the Materials despite the fact that these GICS sectors would

typically be more likely to be less environmentally friendly than say IT and Financials. If the SRI indices did exclude these sectors, clearly, the tracking error of these indices vs. their respective parent indices would be rather large. In fact, typically, the MSCI SRI indices have a good ‘healthy’ amount of tracking error again their respective parent indices – of c. 1.5%-4%. This way, they can indeed provide investors with access to strong ESG screened portfolios while at the same time staying relatively close to the underlying parent index’s performance characteristics.

However, it must be noted that the smaller the underlying parent index, the more difficult it will to be to match sector neutrality between the SRI index and the parent index. For example, the MSCI United Kingdom index has 110 names in it. As the SRI screening process aims to get c. 25% of the parent index to create the ESG ‘all-star team’, that would leave just c. 27 stocks in the SRI index. However,


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remember that these 27 need to be representative across the 11 GICS sectors. That would on average mean less than 3 stocks per GICS sector in the MSCI SRI index. Clearly therefore, the marginal inclusions in the UK SRI index could see a GICS sector in the SRI index go from underweight vs. the parent index to quite overweight vs. the parent.

This is why, where a standard parent index is not very large, we have looked to use extended indices such as the MSCI United Kingdom IMI as the parent index. This index has c. 370 stocks in it and thus provides a far wider base from which to choose a selection of companies with the strong ESG profiles. Another alternative for smaller parent indices is to loosen the inclusion criteria such that the SRI index targets c. 50% of the parent index as opposed to the 25%.

PERFORMANCE CHARACTERISTICS ON MSCI SRI INDICES VS. THEIR RESPECTIVE PARENT INDICES:As mentioned, the common consensus in the past was that investing ethically equated to a drag on performance. However, there is now far greater awareness across the investment industry that this isn’t necessarily the case. A number of white papers have looked into this and have shown that increasingly, companies with strong ESG profiles have delivered healthier investment metrics such as ROEs. The MSCI SRI indices and the UBS ETFs tracking them have shown clear evidence that investing ethically doesn’t act as a hindrance to performance and can in fact sometimes enhance it.

Over the last five years, the MSCI Eurozone SRI index (‘EMU’) and MSCI Japan SRI index have outperformed their market-cap weighted parent indices significantly, by 2.35% p.a. and 1.43% p.a. respectively. The figures for EMU SRI are even better over a three-year period, outperforming the parent by an impressive 3.33% p.a. In general, the SRI indices and ETFs which track them have shown better risk/reward profiles than the parent indices over a 5-year period, the exception to this being the USA SRI. The underperformance of the USA SRI compared to the parent over the last five years (+12.73% p.a. vs. +13.73% p.a.) can be attributed to key tech winners such as, Facebook, Amazon, Apple, Netflix and Google (the ‘FAANG’ stocks) not having strong enough ESG profiles to be included in the USA SRI Index. However, more recently (over a one year period), the USA SRI has bounced back with performance of +20.47% while the USA parent index has delivered +19.07%. (all performance statistics as of 31/08/2018)

Emerging Market SRI has also delivered superior performance over the long term vs. the standard

market-cap weighted index. The EM SRI has delivered +0.40% p.a. excess return over a 5-year period. Admittedly, it has slightly underperformed the parent index over a one-year period (-0.16%). This underperformance is due in part to the EM SRI index being heavily underweight Chinese equities compared to the parent index. This is due to the fact that China has historically had a poor ESG track record. China of course has been a relative EM outperformer in the last year or so. Thus, not having key Chinese winners in the EM SRI index has held back its performance. Amongst the other geographic exposures offered by UBS ETFs in SRI, the Pacific, UK and ACWI have all notched up outperformance against their respective parent indices over a five-year period.

In addition to performance, it’s worth noting that these SRI indices aren’t riskier, as defined by volatility. In fact, the volatility levels over a three-year period for the SRI indices of ACWI, Emerging Markets, EMU and UK indices have been lower compared to their respective parent indices. Additionally, it’s worth pointing out that MSCI’s SRI screening has successfully steered clear of companies including BP, Bayer, Facebook, Volkswagen and a number of others which have fallen foul of key ESG principles. These companies have accordingly paid the price for these failures not only in the consumer and regulatory backlash against them, but also in the subsequent dives in their share prices.

CONCLUSIONESG risks and opportunities exist across most asset classes, including equity and fixed income. Given more evidence of the relationship between ESG ratings and financial performance of companies, integration of ESG analysis into portfolio construction should generally focus on a company’s ability to sustain competitive advantage over the long term. In other words, companies with superior ESG profiles should in the future leverage on their competitive advantage. Of course, ESG assessment cannot be the only driver of the investment thesis, but it should be considered one component of the overall company’s quality assessment. We use extensive datasets to construct portfolios based on individual MSCI ESG Issues Scores to better understand performance but also relationship to financial ratios. We find strong relationship between ESG scores and portfolio risk. The lower the E, S or G scores, the higher the portfolio excess risk, uniformly for all three ESG pillars. We find positive association between Governance top-scored companies and returns. In fact, we find more return and less risk for companies of relative higher Governance scores.

FACTORS IN FOCUSANDREW WALSH

The common consensus in the past was that investing ethically equated to a drag on performance. However, there is now far greater awareness across the investment industry that this isn’t necessarily the case


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A more active approach to the core and satelliteIt’s only ever truly “passive” on the way up – the quantitative experts at asset management firm QMA investigate a more active approach to the Core and Satellite portfolio construction approach

The concept of structuring equity portfolios with a passive core and active satellite has been around for 30 years. It is a strategy that tracks the performance of major

stock market indices (core) while also potentially capturing higher returns through a smaller portion of actively managed investments (satellite). For the past decade or so, this approach has evolved to an ever-larger passive core (with some elements of smart beta incorporated) and ever-more concentrated satellites. Yet the primary approach has remained a linear, top-down process, with the overall strategic weightings determined first, followed by core and satellite percentages, with the breakdown (e.g., 70/30) typically fixed through time, and concluding with the choice of the component pieces. What remains unclear is whether this process should be purely linear or more fluid and linked to the macro environment.

Given that the current bull market is now a record nine years old and counting, people have begun to forget how unusual it is. Virtually the entire cycle has been dominated by historically low interest rates, induced by quantitative easing (QE) by the US Federal Reserve and other central banks to propel the economy out of the Global Financial Crisis. As these measures helped to drive up market returns, market volatility and dispersion dropped, making it an almost ideal condition for the growing numbers of passive core investors. However, as we look ahead, many signs have indicated that we are at an inflection point. It is hard to pin down the exact transmission mechanisms, but with the rollback of QE, the start of the rate hiking and inflation cycle, the projected slowing of global economic growth, and the increasing scope for policy missteps on issues such as trade, it is unwise to expect that market conditions will continue to be as benign going forward.

So, when a down market is looming, and a high level of uncertainty and volatility is in sight, how should investors approach their intra-equity allocations? Should they stand pat, counting on a 70/30 (core/satellite) to do the job? Go even more passive to at least reduce active risk? Or is there a better strategy

that can take advantage of this inflection point? Particularly for high net worth individuals with an absolute return philosophy, these are all critical decisions. Before we get to our solutions, though, it’s important to add some context by taking a quick step back and looking at how the passive core-active satellite became so popular in the first place.

THE COUNTER-CYCLICALITY OF ACTIVE MANAGER RETURNSWhen index funds started to sweep the market in the late 1980s – with their low fees, transparency and tax efficiency – also born was the idea of a passive core. Nowadays, with technology making information widely available and with exchange traded funds (ETFs) offering an ultra-low cost and liquid alternative to active management, passive vehicles have seen increasing dominance in portfolio cores, while active retail investors have become an ever shrinking presence. This, in turn, has left fewer amateur active mistakes for institutional investors to take advantage of, making alpha even harder for some managers to find and ultimately driving more investors into the arms of passive. The large-scale retail nature of today’s passive vehicles also serves to magnify the impact and persistence of broad-market trends that can overpower fundamentals for some time. This was seen in the yield trade of the post-crisis period and in the FANG-driven tech wave of the past couple of years, both of which have further challenged many active managers’ ability to outperform, particularly after fees.

Yet the investment industry has a way of adapting to such structural changes. The growing adoption of performance-based fees in the institutional space is an example of how some active managers may begin to tilt a key portion of the playing field back in their favor. What active managers have a harder time overcoming are the more cyclical forces that can periodically wring the markets of the very conditions they depend on for differentiated returns.

A recent study (2017) published by our colleagues at PGIM’s Institutional Advisory & Solutions (IAS)

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QMA is the quantitative equity and global multi-asset solutions business of PGIM, the global investment management businesses of Prudential Financial, Inc. Today, we manage approximately $127 billion in assets for a wide range of global clients.


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group examined the impact of market conditions on active equity management and found a strong counter-cyclical pattern in active manager returns. The IAS team parsed out the past 21 years of US large-cap active manager returns into three-month blocks, ranking them into quartiles based on volatility, dispersion and market performance. They showed that managers generated their strongest excess returns in the periods characterized by the weakest market performance, highest market volatility and greatest dispersion between stocks, and their weakest returns in the strongest, least diff erentiated markets. Results demonstrated that the post-crisis years exhibited sustained levels of low dispersion over an unusually extended time frame. This is consistent with the recent drought of active manager performance, likely due in no

small part to the lack of diff erentiation present in the market. IAS found it unsurprising that active equity managers have remained under pressure. Conditions that are conducive for active management, after all, have been lacking for several years. They also noted that investors should keep in mind that conditions do change.

The IAS report went a step further to examine how diff erent types of active managers have performed under diff erent types of market conditions. One comparison they drew was between fundamental and active quantitative managers. As defi ned by eVestment, fundamental managers typically employ more traditional stock-picking techniques and high degrees of active share to build more concentrated portfolios, while quantitative strategies use systematic, factor-based

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FACTORS IN FOCUSQMA


FIG. 1: MANAGER RESULTS ARE COUNTER-CYCLICAL (JAN. 1996 – DEC. 2016)

FIG. 2: AVERAGE EXCESS RETURN FOR MEDIAN US LARGE CAP MANAGERS, BY MARKET DISPERSION AND VOLATILITY QUARTILES

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tility

Stdev of 21 days' daily SP500 PR * sqrt(252) (LHS) Median (Annualized 21d vol) since 1996 = 14.87% (LHS) S&P 500 Security-Level Dispersion (RHS) Median Dispersion since 1996 = 7.58% (RHS)

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techniques to construct diversifi ed portfolios with larger numbers of small bets.

As shown in Figure 2, fundamental managers exhibit a great deal of sensitivity to both volatility and stock dispersion, essentially generating almost all of their excess returns in high-volatility, high-dispersion markets. In contrast, quants exhibit a much more stable and consistent return pattern across market environments. For an even more in-depth view, the IAS team next constructed a 4x4 matrix representing quartiles of market returns and dispersion (and volatility), each measured on a three-month rolling basis.

This enabled them to categorize market environments into diff erent sub-types. For example, markets of “diff erentiated decline” (low market return/high dispersion) included the market-bottom of the fi rst three months of 2009, while “coordinated decline” (low market return/low dispersion) included the euro crisis of May-June 2011 and the

Chinese stock market meltdown of June-August 2015. As shown in Figure 3, fundamental managers again generated most of their returns in a select handful of the most diff erentiated and distressed markets, while quants delivered lower highs but across a much larger swath of the grid.

As if on cue, in the eleven months following the initial March 2017 release of the IAS study, active managers staged something of a comeback as dispersion followed by volatility re-emerged and ultimately led to the dramatic equity market sell-off of early February 2018. By May of 2018, Bank of America Merrill Lynch and Goldman Sachs had both issued reports on the “stock picker’s market.” As Goldman’s noted, 60% of active US large cap managers were beating their benchmarks through the fi rst four months of 2018, putting them on pace for their best year since 2007. Among actively managed funds with a focus on growth stocks, a record 78% were outperforming. Even value funds (after struggling

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FIG. 3: AVERAGE ANNUALIZED EXCESS RETURN FOR MEDIAN FUNDAMENTAL AND QUANTITATIVE US LARGE CAP CORE MANAGERS

FIG. 4: PERCENTAGE OF ACTIVE MANAGERS BEATING THEIR RESPECTIVE BENCHMARK YEAR TO DATE (Q1 2010-Q22018)


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through an especially rough few years) were faring well, with 69% outpacing their indexes.

Just a couple of months later, though, those conditions had evaporated as the market recovered to its pre-February 2018 crash highs. In late July, J.P. Morgan reported that just 41% of managers were outperforming through June compared to 52% the previous year (Figure 4). A particularly tricky combination of rising stock correlations and narrowing stock leadership by the still-surging FANGs dragged on returns of fundamental managers, while a slew of policy-driven narratives (the tax cut earnings windfall, mounting trade tensions, etc.) cut into the ability of quants to translate economic fundamentals into incremental gains. This further corroborated the counter-cyclical patterns for active management detailed in the IAS study.

THE NEW MORE ACTIVE FRAMEWORKThe original IAS fi ndings, lending strong support to the suspicions of many that low market returns, high volatility and high dispersion favors active management, have empowered us with new insights to help our clients think through their equity portfolio construction options for the coming market environment. First, the market environment should play a greater role in core-satellite construction. On the other hand, it is invariably diffi cult to predict exactly which kind of up or down market environment is likely in the future. This suggests that the portfolio should still be anchored to a core of strategies that provide the greatest effi ciency in converting risk into returns across the broadest range of environments. As quants appear to exhibit a higher degree of effi ciency and consistency across a greater variety of market types, it is time to rethink the role of these strategies in a portfolio. Rather than viewing quant as simply another band on the active spectrum, perhaps a better approach is to move them all the way to the center of the core, and even to replace passive.

In addition, the IAS study strongly suggests that under many less favorable market conditions, investors benefi t from being more active. One way is to increase active satellite exposures. But in many cases, particularly if the goal is absolute returns, a more eff ective and consistent approach is to replace a big part of the current “passive” core with active quant strategies. To test these hypotheses, we generated optimal large-cap equity portfolios consisting of a passive and quantitative core with fundamental satellites. We evaluated how the optimal allocations of all three would change depending on the market regime.

We identifi ed market regimes by calculating the rolling, three-month realized volatility or return of the

S&P 500. The sample of returns was split, based on those in the top half or bottom half of realized volatility or top half or bottom half of returns. For each market regime, we generated 1,000 random portfolios and calculated each one’s Sharpe ratio using the median manager returns during each regime. The 10 portfolios with the highest Sharpe ratios were then averaged to provide an optimal portfolio for each market regime.

We performed the optimization net of management fees (estimated using the aggressive expense ratio assumptions for quantitative and fundamental managers from IAS’s study). We believed this was important both for capturing a key source of the higher risk-return effi ciency of systematic quant strategies — their relatively low fees compared to higher-active fundamental managers — and also more realistic, in that quants obviously still have higher expense ratios than passive.

Further, by choosing portfolios that maximized Sharpe ratios (rather than excess returns or information ratios), we were making a conscious decision to place the core-satellite construction in an absolute return context. In eff ect, we were seeking to erase the single hard line of demarcation in the standard linear benchmark-oriented approach, and in its place create two more fl exible lines — one determining the size of the core, the other determining the size of passive and active quant allocations inside the core — each of which could be moved up or down in response to the expected macro return environment.

Figure 5 provides a summary of what we believe to be the ideal allocations in diff erent market regimes. The fi rst two bars on the left show the recommended allocations in a low-volatility regime and a high-volatility regime. The analysis suggests that when volatility is low, the investor should make a signifi cant allocation to the core portfolio that tilts strongly toward quantitative managers. The gulf between the quant and passive allocations during these low-volatility regimes is somewhat surprising given the high correlations between passive and active quant strategies (data not shown), but quants’ ability to consistently grind out higher returns net of fees turns out to be a signifi cant diff erence maker. By contrast, more active strategies appear to struggle to fi nd enough big “wins” during a low-volatility regime to overcome their fee disadvantage. However, the opposite is the case in high-volatility markets, when the satellite fundamental managers are allocated a much greater share. Fundamental managers are more nimble at exploiting the volatility, better suited to avoid drawdowns and take advantage of rebounds.

The next four bars show core-satellite allocations for market regimes based on both volatility and

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FACTORS IN FOCUSQMA


Rather than viewing quant as simply another band on the active spectrum, perhaps a better approach is to move them all the way to the center of the core, and even to replace passive

BB_1218_FINAL.indd 27 25/01/2019 08:40

market performance. These portfolios bear a strong similarity to their low-volatility and high-volatility counterparts regardless of the market return level. In a low-return, low-volatility regime, the investor should make a sizeable allocation to the core portfolio, with a decided preference toward quantitative managers. Interestingly, a similar pattern holds for high-return, low-volatility markets, albeit with a modestly larger allocation to passive, as the benchmark can be tough to beat when markets are calmly trending higher. During the high-volatility regimes, the allocation to the satellite fundamental managers becomes dominant whether it is a low-return or high-return period. This is due to fundamental managers’ ability to contain losses better than the quants or passive strategies during highly volatile periods of declining markets. In addition, when markets are volatile but rising, the fundamental managers are better able to take advantage of the big market swings on a risk-adjusted basis. Notably, compared to either quant or fundamental, the passive strategies are allocated relatively small amounts of capital across all of the different regimes, even when returns net of fees are evaluated.

While these are optimal portfolios conditioned on the market regime, the investor may not necessarily know exactly which regime they are in. To address this issue, we constructed a baseline portfolio, a portfolio weighted by a higher risk of volatility, and a portfolio weighted by a lower risk of volatility (Figure 5, three bars on the right). The weight of each asset in each portfolio is multiplied by how often the regime has occurred historically, and then they are summed to produce a final probability weight. Weighting by regime also opens the door to a scenario analysis. For

example, if the investor expects a greater risk of more volatile periods ahead, it may be more appropriate to increase the allocation to the fundamental managers further. Alternatively, if the investor expects volatility to stay relatively contained, then they may allocate away from the satellite and increase exposure to the core managers, with an emphasis on the quants.

It is important to note that this analysis does not incorporate the inherent uncertainty in picking active managers, which adds another level of difficulty for consistent active returns. The returns of the quantitative and fundamental managers are assumed to be those of the median manager. But, in practice, an investor may not achieve these. The challenges arise for two main reasons. First is the issue of performance persistence. A manager might have strong performance versus its peers one year and weak performance the next. As QMA has shown in prior research, this variability is especially pronounced for fundamental satellite managers, even on established performance measures (return momentum, information ratio, etc.). In contrast, the performance of quantitative core managers is more stable. A second challenge in selecting managers is the wide dispersion between top and bottom performers, particularly among the most concentrated managers. Not only is it harder to identify a good fundamental manager based on performance, but the price of being wrong is much steeper. We believe the confidence of investors that they can achieve their expected returns should also influence the allocation to both core and satellite.

CONCLUDING THOUGHTSHistorically, the core-satellite decision has been a linear process. We believe it is time to consider a new process — one that is ultimately dynamic and shaped by macro environment considerations. Market conditions since the financial crisis have contributed to the idea of a large passive core. However, many less benign market environments, including those likely ahead, favor a higher level of activeness, both in core and satellite exposures. Our original research strongly suggests that active fundamental managers excel in highly volatile environments, while quant managers deliver more effectively and consistently across a wide range of market environments. Therefore, when markets are more volatile a higher allocation to fundamental satellite managers is optimal, whereas in less volatile markets the optimal allocation is to the core — particularly a core that is quant-tilted rather than passive. Furthermore, when the uncertainty of forecasting the exact market environment and selecting good managers is considered, we believe a strong allocation to good quantitative core managers will enhance the chances for continued success.

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FIG. 5: CORE-SATELLITE ALLOCATIONS BY MARKET REGIME


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THE ARTICLE BELOW GIVES A SMALL insight into the academic perspective on smart beta. The short summaries below give a brief outline of the most cited new studies, published in the past five years.

Most-cited academic studies since 2013‘Is Smart Beta Really Smart?’, Burton Malkiel, The Journal of Portfolio Management 40.5 (2014)• Smart beta portfolios do

not consistently outperform and when they do produce appealing results, they flunk the risk test.

• “Smart beta portfolios have been the object of considerable marketing hype. They are more a testament to smart marketing rather than smart investing.”

• “All smart beta strategies represent active management rather than indexing.”

It’s been some years since A Random Walk Down Wall St was first published, but this article shows Burton Malkiel still believes market cap weighting is the way to go. In this article, Prof Malkiel argues that when smart beta funds outperform, it’s because they take on more risk. And when smart beta ETFs do temporary outperform on an equal risk basis it’s never long before they revert to the mean.

He also suggests that factor investing is an investment bubble built on an academic bubble. This is because “the actual records of smart beta portfolios run with real money do not in general replicate the results suggested by academic studies.”

‘Smart Beta 2.0’, Noël Amenc, Felix Goltz, and Lionel Martellini, EDHEC-Risk Position Paper (2013)• The state of the literature

assessing smart beta is, at present, terrible.

• Access to data on the performance, composition and risk of the indices is restricted or costly. And many of the nominally independent sources of information are compromised.

• Evaluating smart beta is made harder by index providers and ETF sponsors, who keep their methods secret (as it’s their IP) and use of ad-hoc methods when making products.

There is very little independent assessment of smart beta and most of what parades as assessment is product literature, designed to sell indices, funds, or some kind of advice. In this sense, smart beta is like active management in more senses than one. It uses what is, effectively, active management of factors (mechanical alpha).

And then backs up its funds with unassessed marketing claims.

‘Finding smart beta in the factor zoo,’ Jason Hsu and Vitali Kalesnik, Research Affiliates (July) (2014)• There are now too many

factors, with some quant shops offering exposure to as many as 82; and studies reporting the existence of hundreds.

• Most of these factors will vanish as they have not been tested out of sample and are backed up by low quality data. A good example is the small cap premium, which hasn’t worked since 1980.

• As academics and seasoned industry professionals get on top of this the number of factors will decline.

As much as 50% of factors reported in the literature are based on junk scholarship, including bad data, incomplete formulas and a lack of out of sample testing. According to Research Affiliates, there are really only three that work: value, low volatility and momentum. And it’s unclear to what extent – if at all – momentum can fit in an index.

The state of play is mostly thanks to Ph.D. candidates who have been too eager to find new factors.

What do academics think about smart beta?One of the running themes of this edition of Beyond Beta is how smart beta ETFs differ from the academic picture of factor investing. But what do academics think of smart beta? And how is smart beta being discussed in the ivory tower?

CLOSING REMARKSRESEARCH ROUND UP


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Factor Index UpdateParala’s Steve Goldin returns with our regular deep dive into the major factor indices used by market leading ETFs. He looks at how they’ve performed over the last few years, which parts of the business cycle they are most sensitive to, and what overlap they have with other factors

JUST TO RECAP FROM THE FIRST ISSUE OF BEYOND BETA, we’ve drilled down into a fairly comprehensive universe of major factor indices. In all we’ve crunched the numbers for the following:• 186 US equity factor indices• 168 of which have more than 5 years of history which are still

being maintained and published• This comprehensive range of indices spans size, style, quality,

momentum, dividend, and low volatility factors• We’ve also included 5 US equity ESG indices

Using this universe of well-known factor indices, we’ve constructed what we call Beyond Beta composites where each composite index includes all the indices classifi ed by their stated objective. For the composite performance, only indices run by mainstream index providers were included where the methodologies are publicly available. This likely has only a de minimis eff ect since most fund managers (i.e. Fidelity) which use self-indexing have very short histories i.e their indices were launched solely to support their product.

Crucially we’ve started our analysis using US factor indices only, simply because of their breadth of coverage and longer performance histories compared to other regions and markets. One other observation on our methodology – the population of Dividend, Growth, Momentum, Quality, Low Volatility indices were primarily large cap in nature and therefore the small sample of Small Cap indices for these objectives were removed rather than bias the overall universe of indices.

So, what do the numbers tell us about returns through to September 2018?

The complex looking chart below reveals all, on annualised returns basis for the last 1, 5, 10 and 20 years. For us, a number of key narratives emerge.• Momentum was the best performing over a 1 year, followed by

Growth and Value which proved the worst in performance terms• Over 20 years Growth lagged the most followed by Large Cap

while Small Cap was the best performer• If we looked over calendar years we would see the sorting

from best to worst would move fairly substantially year by year indicating that diff erent factors perform better or worse at diff erent points in the business cycle

The next chart below breaks the performance of these factor indices into their relevant alpha and beta component parts. On this basis, alpha can be considered a form of tracking error which is not explained by the factor indices exposure to Fama French risk factors (market, size, book-to-market value) or momentum. The alpha (tracking error) is further broken down into that which is linked to the business cycle and that which is idiosyncratic to the indices themselves.

Using this narrative lens, we see that the bulk of the factor indices returns can be explained by their risk factor exposure (the Green line) – these include the obvious candidates such as Market, Size, Book-Value-to-Market and Momentum.

The Red line focuses on Alpha or the tracking error component (which we call time varying alpha) which is in turn correlated with the business cycle. This tracking error may come from a combination of index providers using diff erent defi nitions of the

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Using this narrative lens, we see that the bulk of the factor indices returns can be explained by their risk factor exposure (the Green line) – these include the obvious candidates such as Market, Size, Book-Value-to-Market and Momentum

30%

25%

20%

15%

10%

5%

0%1 years 5 years 10 years 20 years

■ BB US Dividend Factor■ BB US Growth■ BB US Large Cap■ BB US Low Volatility

■ BB US Momentum■ BB US Quality■ BB US Small Cap■BB US Value


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factors, implementations, sector tilts, sector rotations (in the case of dynamic multi-factor and smart beta indices).

The last chart below takes a deeper dive into the alpha tracking error measure. It contains various components:• The red line is called time-varying alpha and represents the

average tracking error from the residual return of the factor index universe correlated with the business cycle. As you can see, it is a fairly substantial component

• The negative constant alpha represented by the blue line is the tracking error that is idiosyncratic to the indices themselves.

• Toward the end of the analysis we see the tracking error narrow. This is probably due to the reduction in cross-sectional variance in the returns of the factor indices themselves. This is a phenomenon seen across equities and other asset classes in recent times which has led economists to lower their medium-term expectations for asset class returnsOur bottom line based on this analysis? That a large portion

of time-varying alpha for purely passive instruments is tracking error linked to the business cycle. If this is true, which components

of the business cycle are likely powering those returns? A closer look at specifi c business conditions shows that exposure to infl ation sensitivities has been a big positive contributor to the time-varying alpha (tracking error) for many industries (especially energy) whereas exposure to credit sensitive industries in 2008 contributed negatively to factor index performance - an example of the latter would be the fi nancial sector.

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CLOSING REMARKSFACTOR INDEX RETURNS

What’s also crucial to note, however, is that dispersion across the universe has narrowed with tracking error shrinking notably since 2014. This is in keeping with the well-noticed fact that stock dispersion has declined in recent years

Our bottom line based on this analysis? That a large portion of time-varying alpha for purely passive instruments is tracking error linked to the business cycle

1%

0%

-1%2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Defi nitions for the decomposition of risk factor returns• Total Return = Constant Beta + Constant Alpha + Time-

Varying Alpha • Constant Beta = The portion of an assets return

explained by benchmark risk factors and premia.- Equity market beta – broad market cap equity benchmark- Size premium – Small minus Big equity returns (a zero-

weight benchmark)- Value premium – Value minus Growth equity returns (a

zero-weight benchmark)- Momentum – Trailing 12-month Top 3 minus Bottom 3

sector performance (a zero-weight benchmark)- One would expect virtually all of a factor index’s return

to be explained by benchmark risk factors

• Alpha – For active fund managers this equates to skill and for passive securities it is the portion of the return not explained by its risk factor exposures and can be thought of as a form of tracking error.- Constant Alpha – For active fund managers this

is their ‘all-weather’ security selection skills and for passive securities, it is the long-term average over/under performance uncorrelated to the business cycle.

- Time-Varying Alpha – For active fund managers this is the portion of their skill that is sensitive to the business cycle and for passive securities, it is the excess return of the index (after accounting for beta) that is correlated to the business cycle. Sector tilts are an example.

-1%

0%

1%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Return

Average total alpha across all assets

Total time-varying alpha

Constant alpha

Average total alpha across all assets

Total time-varying alpha

Constant alpha


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HOW SENSITIVE ARE FACTORS AND ESPECIALLY FACTOR-based indices to changing macro-economic conditions? We’ve crunched the data on a collection of fi ve market leading US value indices to see how they might react to a changing economy. Are smart beta ETF buyers buying into these value friendly indices, getting the factor exposure they expect or are they opening up their investors to hidden macro risks?

To help answer this hugely important issue we’ve closely examined a long series of historical data sets all the way through to the end of H1 of 2018 for fi ve major US focused value indices provided by FTSE Russell, Morningstar, S&P Dow Jones, Wilshire and MSCI. We’ve focused our analysis on two sets of ever-changing variables – fi rstly beta exposures based on the classic Fama French exposure models. In addition, we’ve also looked at the sensitivity of these value indices to major macro-economic variables such as infl ation or interest rates.

The fi rst two charts below map out the classic risk factor exposures of the fi ve indices – the Fama French risk factors used in this analysis include Market Beta, Size Premium, Book-to-Market (Value Premium) with Momentum added as an additional risk factor for good measure.

The fi rst chart below shows Market Equity Beta on the vertical axis and Size on the horizontal axis. The chart demonstrates that all the Value Indices have Equity Market Beta below 1 with some as low as 0.87. All of the value indices have a negative Size Premium exposure (i.e. lower cap than Large Cap) representing

their larger cap exposure. It’s also worth observing that all of these widely used indices have a negative size premium indicating they are Large Cap biased but there is also a spread here with some having larger negative exposures than others.

The second chart below shows clearly that the fi ve value Indices we’ve tracked have a positive exposure to the Momentum Risk Factor with two more signifi cant than the others. All of the Value factor indices have positive exposure to the Value Premium

The table below replaces the two charts above with an easy to reference table which shows all the key numbers for the fi ve highlighted ‘value’ indices.

Market Beta

Size Premium

Value Premium Momentum

Russell 1000 Value

0.93 -0.16 0.35 0.07

Morningstar US Large Value

0.87 -0.29 0.37 0.07

S&P 500 Value 0.98 -0.13 0.30 0.01Wilshire US Large Value

0.87 -0.19 0.27 0.05

MSCI USA Large Value

0.89 -0.26 0.30 0.03

The next part of this analysis focuses on the sensitivity of these ‘value’ indices to changing macro-economic variables or rates – all based around the concept of business cycle sensitivity. It’s also important to say that

Inside The Black Box: Value indices deconstructedSteve Goldin from London based research fi rm Parala investigates just how sensitive leading US value indices are to changing macro-economic factors

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-0.5 -0.25 0.00 0.25 0.5

-0.5 -0.25 0.00 0.25 0.5

Mar

ket e

quity

bet

a

Mar

ket e

quity

bet

a

Size premium

Size premium

1.5

1.25

1.00

0.75

0.50

0.50

0.25

0.00

-0.25

-0.50


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we’ve looked at the combined alpha and beta (total return behaviour) sensitivity of the factor indices to the business cycle shown in the charts below, rather than focussing just on the tracking error due to time varying alpha

The two charts below show the factor index return (both beta and alpha components) correlated to the business cycle. All the Value factor indices have a negative sensitivity to the default spread (BBB – AAA corporate bond yield) with Morningstar Large Value having the least negative sensitivity and S&P 500 Value the most negative sensitivity.

All the Value factor indices also have a negative sensitivity to the term Spread (10 year – 3-month treasury yield) with Wilshire US Large Value having the least negative sensitivity and S&P 500 Value the most negative sensitivity

Next up we look instead at two additional macro-based indicators – short term interest rates and infl ation rates. All the US Value factor indices have a negative sensitivity to changes in short term interest rates with MSCI USA Large Value having the least negative sensitivity and Russell 1000 Value the most negative sensitivity.

It’s also worth observing that all the all the US value factor indices have a negative sensitivity to infl ation growth. Given this negative sensitivity, the Value factor indices would be expected to be negatively impacted in a rising rate, raising infl ation environment.

Our last set of macro-economic variables move beyond traditional macro rates and focus on industrial output and market turbulence. The fi rst chart shows factor index sensitivity to industrial production. In periods of positive industrial growth, the Wilshire US Large Value would be expected to do best with Morningstar US Large Value the least aff ected by changes in economic industrial growth.

The next chart shows the sensitivity of these factor indices to movements in ‘fear gauge’ otherwise known as the VIX, which in turn represents time-varying volatility, a measure of investor uncertainty. All the US value indices tracked are negatively impacted by equity uncertainty, with the Russell 1000 Value index most sensitive.

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CLOSING REMARKSVALUE INDICES

What’s also crucial to note, however, is that dispersion across the universe has narrowed with tracking error shrinking notably since 2014. This is in keeping with the well-noticed fact that stock dispersion has declined in recent years

SENSITIVITY TO DEFAULT SPREAD

SENSITIVITY TO INFLATION

SENSITIVITY TO INDUSTRIAL PRODUCTION

SENSITIVITY TO VIX

SENSITIVITY TO TERM SPREAD

-1.50

-1.58

-1.66

-1.74

-1.82

-1.90

-1.10

-1.13

-1.16

-1.19

-1.22

-1.25

0.050

0.040

0.030

0.020

0.010

0.000

-0.0120

-0.0135

-0.0150

-0.0165

-0.0180

-1.1

-1.2

-1.3

-1.4

-1.5

-1.6

Mstar US Large ValueWilshire US Large Value MSCI USA Large Value Russell 1000 ValueS&P 500 Value

Mstar US Large ValueMSCI USA Large Value Russell 1000 ValueWilshire US Large Value S&P 500 Value

Wilshire US Large Value Russell 1000 ValueMSCI USA Large Value S&P 500 ValueMstar US Large Value

Mstar US Large ValueMSCI USA Large Value Wilshire US Large Value S&P 500 ValueRussell 1000 Value

Wilshire US Large Value MSCI USA Large Value Russell 1000 ValueMstar US Large ValueS&P 500 Value

SENSITIVITY TO SHORT-TERM INTEREST RATES-0.4

-0.5

-0.5

-0.6

-0.6

-0.7

MSCI USA Large Value Wilshire US Large Value Mstar US Large ValueS&P 500 ValueRussell 1000 Value


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Beyond Beta is published by

E: [email protected]: www.etfstream.com

© 2018 ETF Stream Ltd

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