beta, and alpha. if not, you run the risk of creating a ...€¦ · alternative index construction...

Facilitating debate on the markets, strategies and investing | @PortfolioForum | 19/20 May 2015

Portfolio construction of the future will focus on 3 risk buckets

Portfolio construction should focus on three risk buckets – beta, smart beta, and alpha. If not, you run the risk of creating a poorly diversified (that is, over diversified) portfolio – and, worse, a portfolio that costs far more than it should.



Portfolio construction of the future will focus on 3 risk buckets

Michael Furey

Managing Director, Delta Research & Advisory (Brisbane)


Only once in a generation there is an opportunity to look at portfolios in a different way and this is the way

Its part of the evolution of developing our Investment Philosophy and beliefs

It will change the way investing is done by portfolio manager at the securities level and strategy design and manager selection levels

You will hear more and more of this into the future

Portfolio Construction of the Future

PortfolioConstruction Forum Symposium 2015 (PortfolioConstruction.com.au/Symposium)

According to Investopedia…

Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices

Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way

Examples include Value (low PE or Price/Book), Size (Small market cap), Momentum (last year’s best performers), Carry (Higher yielding securities), Low Volatility to name a few.

Smart beta strategies may offer the return benefits of active strategies but with the low cost implementation benefit of passive strategies

What is Smart Beta


The components of returns are…1. Market index (market beta)2. Smart Beta (or risk factors)3. Pure alpha above and beyond smart beta

A significant proportion of active management comprises beta and smart beta…so…

Investors should have greater consideration of smart betas in their portfolios

Investors will demand active managers stop producing smart beta and focus on pure alpha

Key Messages


The framework

Source: Smart Beta: The Owner’s Manual, R Kahn & M Lemmon, Journal of Portfolio Management (Winter 2015)

“Investment policy explains more than 90% of variability in total returns” – Brinson, Hood, and Beebower (1986)

Styles such as Value, Growth, Size, Momentum, and Carry

Why we pay the big bucks


Market Index

Australian Debt

Bloomberg Ausbond Composite 0+ TR

Australian Shares

S&P/ASX 200 TR

Global Debt

BarCap Global Aggregate TR Hgd $A

Global Shares

MSCI World GR

Market and Smart Beta Definitions(for the purposes of the research about to be presented)

Smart Beta Australian Debt

BBB - AAA

Australian Shares Value – Growth Small – Large

Global Debt High Yield – Market

Global Shares Value – Growth Small – Large


Active Core funds are all actively managed funds that are likely to play a core asset class role in a broader portfolio.

The market is the most influential factor

How much risk is explained by the Market (Active Core Funds)

Average = 82% Average = 92% Average = 63% Average = 72%

n=21 n=97 n=17 n=101


How much risk is explained by the market?(All Flagship Strategies)

Average = 66% Average = 82% Average = 45% Average = 59%

n = 42 n = 215 n = 56 n = 197

Flagship strategies are all wholesale funds in the investment universe

A spread of market influence exists…but still the market is a dominant factor


On average across all managers, security selection and timing accounts for most risk by individual managers…but there is still a reasonable proportion accounted for by Smart Beta

Risk explained from non-market bets


Created 1,000 portfolios by randomly selecting combinations of 10 managers equal-weighted for each asset class...Monte Carlo simulation

How does the make-up of the risks change?

Let’s Diversify


Smart Beta contribution to total active risk has increased significantly

…meaning “Pure Alpha” provided by the active managers contributes less

How does the make up of active risk change?

Up from 6%

Up from 33%

Up from 37%

Up from 18%


Smart Beta strategies must play a bigger role in portfolios

We still must form views of Smarter Beta return and risk potential

Investors will demand less smart beta and greater focus on “pure alpha” from active managers

Smart Beta is cheaper so why pay the big bucks to active managers

Active managers achieving returns from Smart Beta will become less and less as Smart Beta strategies become more and more

Portable alpha?

Portfolio Construction of the future


Lower costs

Higher returns for same risk

Risk reduction from high cost underperformance

Clear explicit roles for each investment in a portfolio

Evidence supported investment strategy

What does this mean for investors?


Thank you & QuestionsMichael Furey

[email protected]

+61 432 002 472


mailto:[email protected]

Positive Alpha across Minimum Vol, Momentum, Small Cap and Value

Why Smart Beta?


The best managers have produced Alpha that is barely better than the “Smart Beta” indices

Best & Worst Managers

Top 6 Performing Global Managers over last 10 Years

Market Factor

Alpha 3.3% 3.5% 3.1% 2.6% 1.9% 1.5%

Beta 0.84 0.79 0.71 0.78 0.99 0.86

R-Squared 0.71 0.61 0.65 0.81 0.92 0.85

Multi Factor

Alpha 3.9% 3.2% 3.2% 2.0% 2.0% 1.5%

Beta 0.89 0.76 0.69 0.80 1.01 0.86

VMG 0.02 0.06 0.06 -0.13 -0.17 0.05

se(VG) 0.12 0.14 0.12 0.08 0.06 0.09SMB -0.40 0.27 0.12 0.03 -0.09 0.01

se(SMB) 0.09 0.11 0.09 0.06 0.05 0.07Momentum 0.05 -0.01 -0.06 0.13 -0.08 0.01

se(Mom) 0.08 0.10 0.09 0.06 0.05 0.06R-Squared 0.75 0.63 0.65 0.83 0.93 0.85

Smart Beta % 16% 5% 2% 11% 8% 0%

MSCI World

Growth GR USD

MSCI World Large

GR USD

MSCI World

Minimum Vol

(USD) GR USD

MSCI World

Momentum GR USD

MSCI World Small

Cap GR USD

MSCI World Value

GR USD

Average Alpha -1.06% -0.16% 1.99% 3.06% 2.97% 1.11%


Australian Shares


Size Premium


Multi-Factor Alpha over last 5 years


Markets…

Bloomberg AusbondComposite 0+

S&P/ASX 200 TR

BarCap Global Aggregate (Hedged $A)

MSCI World GR $A

So how much does the market explain?


What proportion of on-market risk is explained by Smart Beta

Smart Beta

Citi BBB Spread

MSCI Aust Value-Growth + MSCI Aust Small-Large

BarCap High Yield Spread

MSCI World Value-Growth + MSCI World Small-Large



QUESTIONS?

For further information:Refer to the Due Diligence Forum Research Paper available at http://portfolioconstruction.co.nz



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