The rise of smart beta has just got another boost thanks to a study commissioned by Norway’s ministry of finance for its Government Pension Fund Global. It asked index provider MSCI to look into the feasibility of running smart beta strategies for large portfolios. Very few institutions with the size of GPFG’s $400-billion equity portfolio have implemented smart beta strategies yet, mostly because of challenges around investability or liquidity. MSCI, which has around $40 billion benchmarked against its various risk premia, or smart beta, indicies, explored the feasibility of investing a hypothetical portfolio of $100 billion and found that large assets can successfully run on these indices without liquidity worries.
Smart beta, factor-based investing, customised beta, risk premia, call it what you like, it involves investing in an index tilted towards certain characteristics such as low volatility, size or momentum, and is increasingly popular with investors seeking to outperform traditional indices weighted according to market capitalisation. Smart beta indices do what Roger Urwin, global head of investment content at Towers Watson and advisory director at MSCI, talking during an MSCI webinar Designing Portfolios of Risk Premia: Practical Considerations, described as “heavy lifting.” They offer a passive strategy that falls between bulk beta and alpha, but is cheaper than active management. An estimated $200 billion is already invested in smart beta strategies. Examples include Taiwan’s largest pension fund, the $43-billion Taiwan Labour Pension Fund, allocated $1.5 billion to various MSCI Risk Premia Indices last year. In the United Kingdom, Glasgow-based Strathclyde Pension Fund has also ventured, portioning $824 million of its $16.6-billion portfolio to a fundamental index, rating companies on their economic value as opposed to their size.
Tailored to suit
MSCI developed a set of hypothetical indices for Norway’s GPFG tilted towards value, momentum, small cap and low volatility stocks. The brief from Norway was to measure returns, risk and most importantly investability, using a hypothetical portfolio valued at a quarter of GPFG’s equity portfolio and with a daily trading limit of 10 per cent. “They wanted to know if we could build an investable version of risk premia indices and maintain the return premium for a portfolio of this size,” explains Jennifer Bender, vice president in applied research at MSCI. “We built four indices and the return premium was between 60 and 115 basis points – most of our clients would agree this is a significant premium.”
The past does not guarantee the future, honestly
Investability was the key focus of the study. Unknowns around liquidity and costs hitting net returns for big smart beta investors still abound. A tilt towards systematic risk factors means more trades in a portfolio entailing transaction costs like commission for brokers, explains Bender (pictured right).
Ownership stakes in individual companies and trading volumes in individual stocks can also become large, with trades influencing the price the fund can buy and sell. The study looked at the daily trading limit of stocks and how turnover affects replication costs. “We haven’t answered all the questions yet,” she cautions. “At the end of the day we can’t predict the impact on spreads or prices, which are a big component. We won’t be able to see this until large investors implement these strategies, but we have given some indication of the cost to run this kind of strategy for a large portfolio.”
Nor is there any certainty to MSCI’s findings, she warns. Returns for Norway were based on historical data and simulations. Past performance doesn’t guarantee future results and indices can easily underperform after launch.
Up for the long haul
Like all smart beta indices, the Norwegian test saw periods of weak performance with different indices capturing excess returns at different times. It means investors must sign up for the long haul. “Factor investing requires a strong governance structure with clear investment beliefs and board support to withstand periods of underperformance, while aiming to benefit from the potential premia over a full cycle,” says Bender, adding that varying returns can be mitigated by diversification and pursuing more than one strategy at same time. “Risk premia indices go through underperformance, but by combining them we can smooth out periods of underperformance and limit risk,” she says.
As for GPFG, it isn’t planning to change mandates just yet but the fund says it will act on MSCI’s findings. “The analysis carried out by MSCI suggests that it may be possible to tilt the composition of the equity portfolio of the GPFG towards systematic risk factors to a certain extent,” stated Norway’s ministry of finance. “Investment strategies focused on exploiting systematic risk factors may therefore become important in the Fund.” This could mean GPFG becomes another big investor seeking exposure to risk factors alongside its asset allocation, and so pushing the smart beta trend even further.