Beta management comes out of the shadows

There are new and improved ways of enhancing the beta in portfolios. Greg Bright looks at some of the enhancements, or tilts, which have been researched by State Street Global Advisors.

Pension funds have focused much more in the past two years on the beta in their portfolios, wondering about asset allocation for the future and whether to upgrade the importance of emerging markets.

At the same time, and having spent several years cultivating an alpha-seeking culture, they are wondering whether they can do better than just take macro bets on whole markets.

Of course the investment world is more complex than that, however, institutional investors are increasingly discussing the notion of alternative beta. Alternative beta is the term generally given to the systematic enhancement of whole-market strategies – a pre-programmed form of enhanced index management.

These strategies are still index funds but they appear to have advantages over the traditional cap-weighted indices predominantly used by many pension funds as core portfolios.

Fundamental indexing, initially proposed by Research Affiliates Fundamental Indexing (RAFI), has become popular in certain circles. This assesses the fundamentals of each stock across a range of factors, rather than their capitalisation. Critics of this suggest it is little more than a value tilt on the index, but the RAFI promoters would not agree.

State Street Global Advisors (SSgA), a big index and active manager, has also received a lot of interest with some of its alternative beta strategies, in particular its minimum-variance style.

SSgA research over the past few years has shown that low-volatility stocks in a global portfolio tend to outperform, represent a “fourth factor” in the list of styles which can be demonstrated to outperform in most markets over the very long term. The other three are: value over growth, small-cap over large-cap, and momentum.

While many managers incorporate a degree of momentum in their style, in order not to veer too far from the market during a boom period, SSgA cautions against the reliance on that factor.

The latest thinking in beta management, according to Eric Brandhorst (pictured), the director of research at SSgA’s global structured products group in Boston, encompasses a wide spectrum of strategies. These include:

1. Capturing non-traditional risk premia. This can be through extensions to the equity/fixed interest mix by adding infrastructure, convertibles, frontier markets, REITs and so on. Or by going further through looking at commodities, volatility, currencies, gold, inflation and so on.
2. Departing from the market’s allocation of capital through: factor tilts – such as value, momentum and size; optimised strategies, such as minimum variance; risk-reduction strategies, such as equal-weighted indices or GDP-weighted indices; and emulation strategies, such as returns-based or holdings-based strategies.
3. Modifying asset class payoffs: such as having leveraged beta or inverse beta; or such as non-linear payoffs such as protected equity or putting collars on portfolios.

Brandhorst says that the new approaches to beta management provide real opportunities for passive investors to increase returns and/or reduce risk.

However, investors need to consider a number of things, such as the credibility of the investment thesis behind each tilt.

Brandhorst says that investors should remember that some objectives cannot be captured with index strategies and some have high portfolio management costs.

They should also appreciate that the timing of the investment decision may be important and pay attention to explicit costs. They should also be suspicious if the methodology is complex or results are sensitive to small changes.