By Timothy Atwill, Parametric, Director of Research - Alternative Strategies
While passive “buy and hold” investing has long been a staple for investors, there is growing concern that traditional capitalisation weighted approaches may be too risky. Markets fluctuate between boom and bust cycles. Concentrations in the market build up, and then collapse.
Examples include global banking and real estate stocks in the 2000s, technology stocks in the 1990s, and Japanese stocks in the 1980s.
These cycles can cause both passive and active strategies to become dangerously concentrated in just a few stocks, sectors, or countries. In reaction to this, many investors have become interested in a third style of asset management, often referred to as “Smart Beta,” which falls between the pure active and passive paradigms.
Smart beta strategies are often used to replace a pure passive capitalisation-weighted portfolio, or to complement existing passive and active strategies. There is a broad range of strategies, including minimum volatility, equal-weighted, and fundamentally-weighted strategies, among others. While these strategies use very different methodologies, they all focus on portfolio construction as the primary source of alpha. We make a distinction between (1) “indexed” smart beta, which is based on a fixed set of transparent rules with calendar rebalancing, and (2) “managed” smart beta, which is implemented by an investment manager with dynamic rebalancing and enhanced risk management.
Many smart beta solutions we observe fall in the first category, and are simply “new” indexes, which take as their weighting rule some metric other than market capitalisation.
The “Systematic Alpha” suite is a set of “managed” smart beta strategies which seek to capture market returns with less risk, and are based on the concept that one must first diversify, and then rebalance the portfolio systematically. Experience shows how a disciplined, rules-based process has derived significant outperformance over time, relative to strategies that drift and allow concentrations to build up in the portfolios.
Our experience in Europe has shown that (European) investors are usually early adopters and have been faster than some other investors to implement new types of solutions, such as smart beta, and achieving exposure to equity markets in an efficient way. Nordic and Dutch institutional investors, particularly the larger pension funds, have been proactive in seeking alternative ways to build their equity exposures and as such have embraced smart beta before most other investors. In many cases an alpha-beta separation portfolio preceded the move to smart beta portfolios.
Diversify and Rebalance
If diversification is the widely accepted bedrock of modern portfolio theory, it may seem odd for us to refer to it as a source of alpha or as a competitive advantage. However, a close examination of many active and passive strategies reveals a surprising degree of concentration. For active managers, these concentrations reflect their active bets. For passive managers they reflect concentrations in the underlying indexes. Most indexes are constructed to define an investable universe, and not necessarily designed to be a balanced or reasonable portfolio. In contrast, by examining the correlation and contribution to volatility of each member of an asset class, systematic alpha portfolios are built explicitly to have a high level of diversification. The result of this diversification effort is a reduction in the overall volatility of the portfolio, which in turn increases expected returns.
Diversification in systematic alpha portfolios is effected by applying a set of target weights to the portfolio. However, left to their own devices, capital markets, and capitalisation-weighted indexes, tend towards concentration. To prevent that from occurring, the target weights in most systematic alpha portfolios make use of rebalancing triggers to maintain the benefits of diversification. Once a position in the portfolio breeches the trigger around its target weight, a rebalancing trade is merited, to bring it back to target. By remaining disciplined and non-emotional about positions and their historical returns, a systematic alpha strategy generally sells winners and buys losers in every rebalancing trade. While not every rebalancing trade will be profitable, this continual process is expected to add to returns over time. Rebalancing also acts to prevent the inevitable fate of most concentrations – a crash in value. By forcing the strategy to sell into strength and buy into weakness, rebalancing has proven to be a powerful secondary source of potential outperformance in systematic alpha strategies.
A “Managed” Smart Beta
Systematic alpha goes beyond defining the portfolio weights, and combines it with several key implementation aspects. Systematic Alpha portfolio positions are dynamically traded and are not publically disseminated; these strategies are less prone to front running. Second, the dynamic rebalancing built into all systematic alpha strategies is hard to build into a rules-based index, and, to our knowledge, is not a key aspect of any other smart beta solution. Instead, most smart beta solutions depend upon a regular semi-annual reconstitution to true up their underlying positions. Finally, systematic alpha evolves in real time, as the underlying asset class evolves. Many smart beta solutions are only updated periodically, and can miss inflection points in key characteristics of an asset class (e.g. liquidity, transaction costs, or political risks).
Conclusion
Systematic alpha offers a departure from the traditional styles of pure passive and all active asset management. By adhering strictly to the principles of diversification and rebalancing, systematic alpha portfolios seek to tap a source of outperformance which does not depend on being “smarter than the market”. Some skepticism is expected when we offer the time tested methods of diversification and rebalancing as exciting alpha drivers. However, in our experience, the systematic alpha approach, through its disciplined process of reweighting and rebalancing, seeks a stable source of outperformance, accompanied by lower portfolio volatility. We attribute any outperformance in a systematic alpha portfolio to the structure of the portfolio, and not through any fundamental relative return views. By tying together the creation of the portfolio construction rules with real-time reactions in the implementation and evolution of those rules, we feel systematic alpha gives a truly “smart” smart beta.
Parametric launched an UCITS compliant version of its Parametric EM Equity strategy in 2008 under the Dublin domiciled Eaton Vance (International) funds plc umbrella. The fund’s I share has managed to outperform the MSCI EM index for the past five years ending September 30th 2013, while exhibiting lower volatility. The fund has raised over $1.8 billion (USD) over this period, which speaks well about the popularity of the approach for European investors.
Parametric is a subsidiary of Eaton Vance Corp. Parametric’s “Systematic Alpha” suite is a set of “managed” smart beta strategies which seek to capture market returns with less risk and are based on the concept that one must first diversify, and then rebalance the portfolio systematically.
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