This is the latest in a series of pieces in which we discuss the ways new exchange traded products (ETPs) are changing the investment landscape as they attempt to improve on existing structures and strategies. Previous installments have looked at such topics as equal weighted indexing, buy-write strategies, and monthly leveraged exposures. In this one we'll examine the general characteristics of advanced beta. Subsequent articles will follow, examining at a deeper level some of the specific products that have been launched using this broad strategy type.
As the philosophical debate between active and passive management rages on, many have voiced their support for somewhat of a middle ground, namely a fundamental indexing or advanced beta strategy. This encompasses a variety of transparent, rules-based approaches to constructing a portfolio, but with constituent weights decided by factors other than market capitalisation, which tends to hold sway in most purely passive exposures.
Of course it’s not a new idea: Research Affiliates has been running fundamental index strategies since 2004. But finding new ways to put together a broad market basket has been gaining traction of late, with minimum variance and risk-weighted methodologies attracting interest. Since mid-2011, Ossiam has launched several minimum variance exchange traded funds (ETFs), most recently launching the Ossiam ETF FTSE 100 Minimum Variance (UKMV) on the London Stock Exchange. The Ossiam ETF seeks to use stocks' beta and correlation characteristics to weight them in a way that improves upon the risk/return profile of a traditional market capitalisation weighted index.
As such products come to market, it’s important to examine both their advantages and potential drawbacks, many of which are similar to those we’ve discussed before in the context of an equal weighted indexing strategy.
First, the pros. Advanced beta strategies can address some of the major shortcomings of a market capitalisation weighted index, which overvalue the most expensive securities and underweight the cheapest, favouring momentum over mean reversion. Market capitalisation weighted indexing can be particularly problematic on the bond side, as the most indebted issuers are given the largest representation in the index. Re-weighting the basket to favour a different set of factors has the potential to overlay some contrarian viewpoints, as well as improve diversification by customising the sector exposures and upping the focus on small- and medium-sized firms. Furthermore, the simple act of rebalancing when the market pushes prices away from their starting point can lock in gains and force a buy low, sell high discipline.
And there are some structural ways to arbitrage the broader market that such an approach may be able to take advantage of, for example the forced selling of a security when it leaves an index.
A rules-based strategy tilted towards certain characteristics can take some of the things active fund managers think about when building their portfolios, and package them for a low cost, while codifying them within a consistent and transparent set of protocols.
Having said that, it’s worth noting that there are risks and potential disadvantages to this way of doing things. First of all, rules-based models that backtest well are a dime a dozen. The fact that a certain type of stock performed well in the past is no guarantee or indication that it will do so in the future. In practice it can even make it less likely. As people notice, and are increasingly told, that a portfolio of low beta stocks produced strong historical results, money will flow to these stocks, raising their prices and lowering their expected future returns. Similar reasoning would posit that there is far less low hanging fruit for the classic value investor these days, since every newly-minted business graduate has read Benjamin Graham.
Re-assembling a basket of securities might also give up some of the liquidity one gains through a market cap weighted index, as well as taking on more risk by going into smaller companies. Even in the cases where advanced beta strategies can take advantage of structural arbitrages such as forced selling when a name is booted from an index, these can take a long time to play out, and will do no good to the end investor unless he or she hangs onto their ETF units.
Moreover, an advanced beta strategy could well involve higher portfolio turnover than an index, whose constituents probably won’t change often, and that higher turnover could result in higher transaction costs and potential tax implications. Even the explicit costs, as measured by the total expense ratio, may be higher with an advanced beta strategy. Ossiam’s minimum variance fund on the FTSE 100, which uses full physical replication, comes with an expense ratio of 0.45%, which compares to TERs of 0.40%, 0.35%, and 0.33%, respectively, for iShares FTSE 100 (ISF), HSBC FTSE 100 ETF (HUKX), and CS ETF on FTSE 100 (CUKX), which all use physical replication.
Like any portfolio management strategy, advanced beta has its plusses and minuses. It is not an investment panacea, but then neither is pure indexing or unbridled active management. For now, there are no lengthy track records we can look to; newly-launched products will have to build performance histories that back up claims about the efficacy of their approach. If the Ossiam funds are any indication, investors will be able to access these strategies at a much lower cost than most fully active ones. That alone makes them an interesting proposition, to both sides of the debate.
The next piece in our examination of advanced beta will focus on the Powershares RAFI products, which apply fundamental indexing to various areas of the market. We’ll look at the different types of exposure these products are giving investors, and how their performance has stacked up against traditional indices.
This article was originally published February 2012.
