Investors increasingly embrace “smart beta” investing, by which we mean passively following an index in which stock weights are not proportional to their market capitalizations, but based on some alternative weighting scheme. Examples include fundamentally-weighted indices and minimum-volatility indices. In this whitepaper we first take a critical look at the pros and cons of smart beta investing in general. After this we successively discuss the most popular types of smart indices that have been introduced in recent years. Read more about ‘smart beta’ investing.
The $26 billion Australian super fund, Sunsuper, is investing in an increasing amount of exclusive unlisted asset deals. Chief investment officer David Hartley says the difficulties of banks in Europe in particular have led the fund down the path of increasing the amount of debt investments in its unlisted exposure. Much of this has been in distressed debt.
There is a view that a mid-sized fund has optimal economies of scale and stealth in manoeuvre and the ability of anything larger to outperform is dulled. But it is hard to believe that is the case when listening to David Hartley enthuse on the opportunities coming the way of a $26 billion fund. Indeed, Sunsuper might be said to act like a bank or at least a private equity firm in its ownership of unlisted assets, such as the recent majority takeover of the Adelaide based Discovery Holiday Parks.
The advent of Basel II and III has meant private equity, infrastructure and property developers often do not get access to the same readiness of capital from banks. This leaves opportunities for large institutional investors to partner with them. Such deals deepen existing business relationships, not least because it helps managers avoid having to partner with competitors.
Hartley describes the leverage Sunsuper gets. “For some of those deals we help get off the ground you can get a zero fee. [Managers] would prefer to give that opportunity to their good clients, if it means they can do the deal rather than share with another private equity firm. We had one co-investment where we put $15m in and within two months we got back $45m.”
Given such windfalls, it is easy to see why Hartley foresees creating more co-investment relationships, but he is at pains to point out that all are measured on the basis of their relative attractiveness to a listed asset.
“When we look at an unlisted asset, ‘we say what are we replacing?’, ‘what would we have the money in if we weren’t in it?’.”
As well as these opportunities there are more conventional long term private equity deals. In February, Sunsuper announced it had become the 98 per cent owner of Discovery Holiday Parks, a company with 30 sites in Australia.
Here, Sunsuper had initially been a partner with private equity firm Allegro, taking just 28 per cent of the shares. Once the company’s debt issues were sorted out, Allegro and the other investors sold their shares to Sunsuper, while management bought the remaining 2 per cent.
Sunsuper has known the management team at Discovery for quite a while and Hartley says they are appreciative of having a long term institutional investor behind them.
Here, responsibilities extend to hiring an executive search firm to find independent non-executive directors to oversee the management and to liaise with Sunsuper. Under the governance policy of the Sunsuper, its staff cannot sit on the board of an investee company.
In place of banks
Hartley says the difficulties of banks in Europe in particular have led the fund down the path of increasing the amount of debt investments in its unlisted exposure over the last couple of years. Much of this has been in distressed debt (secondary loans), which has provided an impressive 16.7 per cent return per annum since 2004. Here, established relationships with firms such as Oaktree and Loan Star, who are specialists at assessing the security behind bank loans, has been key.
These managers take over bank loans that are viewed as being at risk of default. They make an assessment of the worth of the company to whom the loan has been made and then make an offer to the bank of less than the nominal value of the debt. This is done on the basis that the bank is often willing to realise a loss in return for the certainty of receiving cash they can then recycle. The fund manager then goes to the borrower and offers to walk away from the debt, if the company can pay back a percentage of the debt that reflects the company’s worth.
Hartley is wary of new managers in this space. “You are better off sticking with those who know what they are doing and are very practised at it. Many people who are sticking up their hands right now are not going to cut it.”
Hartley forsees further involvement in the co-investment space, not least because it is a way of stripping out some of the fund manager profits from its overall fee budget.
In common with other big funds, he is aware that the bigger they get, the bigger the profit that fund managers can make from increased funds under management. Or as he puts it, “it does not cost twice-as-much money to manage twice-as-much money”. Funds such as AustralianSuper, REST and Unisuper have taken some management in-house, but Hartley thinks partnerships with managers will provemore profitable in the long-term.
“Setting up an internal team is one way for us to harvest the benefits of scale, but it is good to focus your team on where the most value can be extracted. “Smart partnering” and getting co-investment opportunities is probably a better long term route.”
One of the smart wins from co-investment is the way it educates internal teams on how deals are constructed, allowing them to ask smarter questions of their other managers. If the deal is offered to them on an exclusive basis, they are also given greater time to assess it. Another advantage is greater transparency from more detailed due diligence.
“You get really good insight into how managers are approaching these things. There is a knowledge transfer that is permanent,” he says.
Risk return
Hartley defends the nature of these deals from anyone who might think they pose a higher risk. He cites the greater transparency on the accounts and the business, such as the interest rates paid on their loans, the internal modelling of cash flows, insights into customer bases and knowledge of transactions as all giving a better indication of an asset’s true value than one listed an exchange.
“Who is to say that that modelling is any worse than the last traded price on a listed stock? Arguably I would say a good valuer has got a better idea of the price,” he says.
Sensitive to the notion that the value of unlisted assets is murkier than a listed asset, he questions whether an investor could sell $500m of BHP Billiton shares at the last traded price in a single sale. While the last traded price of an unlisted asset is a reasonable estimate of fair value, so is an independent valuation. When unlisted assets have been sold, Sunsuper “almost invariably” achieved an uplift on the valuation, he says.
Sunsuper at a glance
Returns to June 2013 (% pa) –
Balanced Option
1 year 15.9
3 years 8.0
5 years 4.1
10 years 7.1
Members June 2013 1,038,000
Assets June 2013 $23,926m
Proportion of assets in super default 73%
Net contribution flows 2012/13 $1,649m
The correlation between stocks and bonds in a rising interest rate environment can turn positive. So given the likelihood of a rate rise, what should asset allocation look like if investors are forward looking?
One of the growing trends in asset and risk allocations is to adopt a forward-looking view driven by macroeconomics, rather than a backward-driven view generated by historical statistics.
This is particularly important in the context of a likely rise in interest rates, something a backward-looking view would not incorporate, and the impact that would have on the stock:bond correlation.
Executive vice president and global head of client analytics at Pimco Sebastien Page, says the macroeconomic factors should be a consideration for investors in their asset allocation decision-making, and in the current environment there is a potential change in the stock:bond correlation that could have a significant impact on asset allocation.
“There has been a declining interest rates environment for 20 years and asset class returns and volatilities reflect that. Forward looking, given yields and P:E ratios, likely returns are different and interest rates increases will mean a different asset allocation,” he says. “It is clear in a high interest rate environment there is very different diversification between stocks and bonds, the correlation can turn positive.”
This has implications for how investors hedge risks and for the role of bonds.
A quantitative research piece Page co-authored with four other Pimco colleagues, The Stock-Bond Correlation, shows that from 1927 to 2012 the correlation between the S&P500 and long-term Treasuries has changed sign 29 times, ranging from -93 per cent to +86 per cent.
The paper states that while many factors influence the stock-bond correlation, analysis reveals the importance of four key macroeconomic factors: real interest rates, inflation, unemployment and growth.
The authors say that stocks and bonds have the same sign sensitivity to the real (inflation-adjusted) policy rate and to inflation, while their sensitivity to growth and unemployment have opposite signs. So depending on which factors dominate, the correlation can be positive or negative.
“If growth concerns, such as unemployment or GDP drive volatility, then the correlation can be expected to be more negative,” Page says. “If surprises in interest rates and inflation dominate volatility then you can get a positive stock:bond correlation. Bonds are not hedging as well as they used to.”
“Investors don’t always pay attention to this but it plays a huge part in, for example, risk parity volatility,” he says.
At the same time the stock:bond correlation could be changing, an allocation to alternatives may not be the saviour for portfolio diversification and risk hedging.
In a recent FAJ paper, “Asset allocation: risk models for alternative investments”, Page and his co-authors join a growing academic literature which finds there is no longer a “free lunch” in using alternatives.
The paper runs through analysis of an alternative risk framework to mean-variance optimisation and shows alternatives are exposed to many of the same risk factors that drive stock and bond returns.
“Our paper shows reflecting true mark to market risk would result in lower allocations to alternatives,” he says.
Page recently presented at the CFA Institute annual conference on asset and risk allocation trends, and while the concepts are not new, they are worth noting, because of the momentum with which they are trending.
He says first, rather than relying on a backward-driven view generated by historical statistics, investors should formulate a forward-looking view driven by macroeconomics.
Second, investors should focus on risk factor–based diversification in addition to asset class–based diversification.
Third, investors must recognise the dynamic nature of markets and make asset allocation decisions on a cyclical and secular basis rather than a calendar-year basis.
Finally, risk should not be defined solely as volatility; investors should seek to explicitly measure and manage tail-risk exposures.
China’s biggest sovereign wealth funds need, and want, co-investment opportunities in real assets and private equity and are open to new partnerships with international investors of the right credentials, and the longer term the partnership the better.
This is the feedback of Michael Wadley, a specialist lawyer of Australian origin based in Shanghai, who runs a consultancy advising both domestic and foreign investors on acquisitions, tax and compliance.
The need for such partnerships is not just because of the way these funds have grown in line with the relentless rise in the Chinese economy since 1998, but to their high weighting to overseas assets in mining, real estate, infrastructure and private equity.
The Chinese Investment Corporation (CIC) in its last published accounts, for the year ending 2012, had a 32.4 per cent weighting to the grouping of “long term investments”.
These assets fit in with its stated investment aims, which place repeated and strong emphasis on its dedication to the long term, but also to its aversion to losing money – it is looking at sure bets that will pay out for decades to come.
In this way, CIC purchased a 10 per cent stake in Heathrow Airport, in London, the third busiest airport in the world and has purchased resources with expected growth in demand and potential scarcity, such as mining, water and agriculture.
Wadley estimates a typical long-term target return on direct investments for Chinese sovereign wealth funds is the inflation of the G20 nations plus 1 per cent.
This focus on the long term makes a sharp contrast to Western thinking. He estimates the short-term for Chinese sovereign wealth funds is defined as three years, the mid-term 10 years and the long-term can cover several generations.
Long-term business relationships, a staple of Chinese business life are also key. In entering into such foreign investments, Chinese sovereign wealth funds are looking for co-investors will have local contacts and local expertise to the assets in question, says Wadley, and ideally foreign government backing too.
For such investments, he estimates the “sweet spot” is a 30-40 per cent stake worth around $200 million.
The importance of personal contacts in making business decisions cannot be over-emphasised in China and those investors looking to work in partnership with Chinese sovereign wealth funds should commit to a long-term relationship with plenty of contact.
“You cannot communicate enough,” he says. “If you are thinking about co-investing put a lot of time in, meeting three times a year is not enough, you really need a representative on the ground,” he says.
One of the rewards for meeting such standards of long-term partnerships, is to receive far more detail than is publicly available from Chinese sovereign wealth funds, whose annual reports do not to disclose the names of external fund managers and advisers.
“If you want to know the detail you have got to get to know them, rather than go to the website. If you have the right credentials and background they are very willing to get to know you,” says Wadley.
Risk reporting is increasingly regarded by sophisticated investors as an important ingredient in their decision-making process, authors from EDHEC argue that the effective number of (uncorrelated) bets could be a useful risk indicator to be added to risk reports for equity and policy portfolios.
Risk reporting is increasingly regarded by sophisticated investors as an important ingredient in their decision-making process.
The most commonly used risk measures such as volatility (a measure of average risk), value-at-risk (a measure of extreme risk) or tracking error (a measure of relative risk), however, are typically backward-looking risk measures computed over one historical scenario.
As a result, they provide very little information, if any, regarding the possible causes of portfolio riskiness and the probability of a severe outcome in the future, and their usefulness in a decision-making context remains limited.
For example, an extremely risky portfolio such as a leveraged long position in far out-of-the-money put options may well appear extremely safe in terms of the historical values of these risk measures, that is until a severe market correction takes place.
This was pointed out by Andrew Ang, William Goetzmann, and Stephen Schaefer in their 2009 report to the Norwegian Ministry of Finance “Evaluation of Active Management of the Norwegian Government Pension Fund–Global”.
In this context, it is of critical importance for investors and asset managers to be able to rely on more forward-looking estimates of loss potential for their portfolios.
In recent research produced with the support of CACEIS as part of the research chair at EDHEC-Risk Institute on “New Frontiers in Risk Assessment and Performance Reporting,” we focused on analysing meaningful measures of how well, or poorly, diversified a portfolio is, exploring the implication in terms of advanced risk reporting techniques, and assessing whether a relationship exists between a suitable measure of the degree of diversification of a portfolio and its performance in various market conditions.
While the benefits of diversification are intuitively clear, the proverbial recommendation of “spreading eggs across many different baskets” is relatively vague, and what exactly a well-diversified portfolio is remains somewhat ambiguous in the absence of a formal quantitative framework for analysing such questions.
Fortunately, recent advances in financial engineering have paved the way for a better understanding of the true meaning of diversification.
In particular, academic research has highlighted that risk and allocation decisions could be best expressed in terms of rewarded risk factors, as opposed to standard asset class decompositions, which can be somewhat arbitrary.
For example, convertible bond returns are subject to equity risk, volatility risk, interest rate risk and credit risk. As a consequence, analysing the optimal allocation to such hybrid securities as part of a broad bond portfolio is not likely to lead to particularly useful insights.
Conversely, a seemingly well-diversified allocation to many asset classes that essentially load on the same risk factor (e.g., equity risk) can eventually generate a portfolio with very concentrated risk exposure.
More generally, given that security and asset class returns can be explained by their exposure to pervasive systematic risk factors, looking through the asset class decomposition level to focus on the underlying factor decomposition level appears to be a perfectly legitimate approach, which is also supported by standard asset pricing models such as the intertemporal CAPM or the arbitrage theory of capital asset pricing.
Two main benefits can be expected from shifting to a representation expressed in terms of risk factors, as opposed to asset classes.
On the one hand, allocating to risk factors may provide a cheaper, as well as more liquid and transparent, access to underlying sources of returns in markets where the value added by existing active investment vehicles has been put in question.
For example, the argument in favour of replicating mutual fund returns with suitably designed portfolios of factor exposures such as the value, small cap and momentum factors.
Similar arguments have been made for private equity and real estate funds, for example. On the other hand, allocating to risk factors should provide a better risk management mechanism, in that it allows investors to achieve an ex-ante control of the factor exposure of their portfolios, as opposed to merely relying on ex-post measures of such exposures.
In our research, we first review a number of weight-based measures of (naive) diversification as well as risk-based measures of (scientific) diversification that have been introduced in the academic and practitioner literature, and analyse the shortcomings associated with these measures.
We then argue that the effective number of (uncorrelated) bets (ENB), formally defined in Managing diversification as the dispersion of the factor exposure distribution, provides a more meaningful assessment of how well-balanced an investor’s dollar (egg) allocation to various baskets (factors) is.
We also provide an empirical illustration of the usefulness of this measure for intra-class and inter-class diversification. For intra-class diversification, we cast the empirical analysis in the context of various popular equity indices, with a particular emphasis on the S&P 500 index.
For interclass diversification, we analyse policy portfolios for two sets of pension funds, the first set being a large sample of the 1,000 largest US pension funds and the second set being a small sample of the world’s 10 largest pension funds.
In a first application to international equity indices, we use the minimal linear torsion approach to turn correlated constituents into uncorrelated factors, and find statistical evidence of a positive (negative) time-series and cross-sectional relationship between the ENB risk diversification measure and performance in bear (bull) markets.
We find a weaker relationship when using other diversification measures such as the effective number of constituents (ENC), thus confirming the relevance of the effective number of bets on uncorrelated risk factors as a meaningful measure of diversification.
Finally, we find the predictive power of the effective number of bets diversification measure for equity market performance to be statistically and economically significant, comparable to predictive power of the dividend yield for example, with an explanatory power that increases with the holding period.
In a second application to US pension fund policy portfolios, we find that better diversified policy portfolios, in the sense of a higher number of uncorrelated bets, tend to perform better on average in bear markets, even though top performers are, as expected, policy portfolios that are highly concentrated in the best performing asset class for the sample period under consideration.
Overall, our results suggest that the effective number of (uncorrelated) bets could be a useful risk indicator to be added to risk reports for equity and policy portfolios.
*Lionel Martellini is professor of finance at EDHEC Business School, and scientific director at EDHEC-Risk Institute
Romain Deguest, senior research engineer, EDHEC-Risk Institute
Tiffanie Carli, research Assistant, EDHEC-Risk Institute
The research from which this article was drawn was supported by CACEIS as part of the “New Frontiers in Risk Assessment and Performance Reporting” research chair at EDHEC-Risk Institute.
The risk of a US equity market decline and concerns over the future direction of interest rates has been driving US foundations and endowments’ asset allocation decisions in the past year, with a distinct move away from US equity to global allocations and away from US-focused core to longer duration and high yield.
The latest investor trends report from eVestment shows the US foundation and endowment universe to be moving assets out of their largest allocations of US large cap value, core fixed income, large cap growth, interim duration fixed income and core plus fixed income.
As a result of the low-yield environment, these investors are increasing allocations towards cost-effective, passive, global equity exposures and higher-yield and longer duration fixed income. According to the eVestment report, in changing from low and interim duration US fixed income, these investors have allocated to funds which have been increasing their cash positions, reducing their yield to maturity, but also increasing average weighted coupon, portfolio maturity and duration.
Further these investors are favouring strategies that have shifted their portfolios away from AAA to BBB.
“In order to maintain a certain level of yield, they have been forced to move out on the credit spectrum. This is generally true for any non-alternative strategies that have operated with specific return expectations,” the report says.
It also says that allocations to the hedge funds industry have accelerated over the last three quarters.
Throughout 2013 there were large inflows to credit and multi-strategy funds and entering 2014 investors have heavily increased allocations to long/short equity and event driven strategies, all of which appear to be at the expense of manage futures and macro strategies.
“With multiple surveys illustrating interest in hedge funds, private equity and real assets, along with what have been large aggregate flows into alternative credit strategies, foundations and endowments have been active in searching for new sources of yield and return credit markets while also attempting to reduce exposure to directional movements in rate markets.