Smart Investing

Cap-weighted equity indices are tried and tested, why should investors change?

It’s true that cap-weighted indices have long been the dominant choice for investors seeking passive equity exposures. However, many investors are now reflecting whether these indices are the most efficient way of capturing stock market returns.
Research shows that cap-weighted indices are excessively concentrated on the largest market-cap stocks, so they are not efficiently diversified. In addition, they provide limited access to other rewarded risks, such as size, momentum and value. Cap-weighted indices have, for instance, implicit biases towards expensive and large-cap stocks, so fail to capture value and small-market cap risk premiums.
Huge volatility in equity markets following the 2008 financial crisis convinced many investors of the shortcomings of cap-weighted indices. Some resolved to scale back their equity allocations and switch into bonds as a result. But with yields on bonds now at historic lows, returns are insufficient to meet financial targets. Investors increasingly seek a hybrid of equities and bonds, targeting equity-like returns with bond-like volatility.

Is smart beta the answer? If so, what type of smart beta?

It is certainly one of the answers. Many different types of smart beta now exist in the market. Candriam’s approach principally focuses on risk, and in particular on the finding – surprising to many investors - that portfolios of low-volatility stocks produce higher returns than high-risk stocks. 
Why does this inverse relationship exist? Firstly, active fund managers are paid for outperformance against a benchmark, so they tend to overweight stocks with higher beta and volatility to achieve higher returns. While volatile stocks are likelier to produce higher short-term returns, they are also more popular and so become over-valued, producing lower long-term returns. Second, less volatile nature of low-risk stocks reduces the discount rate at which equity analysts derive a target stock price, justifying higher returns. Lastly, defensive stocks have a steadier cash flow profile, so in severe economic downturns, they have less need to raise extra capital and dilute existing shareholders.

Apart from low vol, what are the other elements of your smart beta strategy?

It is logical to combine low-volatility investing with quality screening, given that the quality of a company is a significant long-term risk factor in an equity portfolio. The definition of quality differs among asset managers, but we define it as companies that are profitable, growing, well-managed, have low financial leverage and a competitive advantage over peers. Research shows that a strategy that goes long high-quality stocks and shorts low-quality stocks earns significantly higher risk-adjusted returns.
Even though high quality stocks are more expensive than average they still outperform over the long-term, showing that investors are willing to pay a premium for higher quality.
Finding companies that match our definition of quality on an historical basis is only part of our mission. As we know, future performance may have little resemblance to the past, so to project a view of a company far into the future and evaluate the durability of its quality takes deep fundamental research.
This requires breadth of analysis, experience of markets and the discipline to focus on the long-term regardless of market movements. Our investment team comprises 11 individuals with specialist knowledge of assigned sectors and geographies. Their average industry experience is over 10 years and our senior portfolio managers have more than 15 years’ experience. In addition, they are supported by our Investment Engineering team comprising eight quantitative experts.

How is your smart beta strategy differentiated from other providers?

We describe our approach to smart beta as “next-generation”.
Since both low-risk and quality investing yield positive returns, we have combined the two approaches to achieve even higher risk-adjusted performance. In addition, the rewards for exposure to low risk and quality tend to vary over cycles, so combining them allows investors to diversify their sources of outperformance and smooth performance across market conditions. 
Even though the combination of low risk and quality has delivered excellent results in the past, it is reasonable to question whether this outperformance will persist. We have found that while quality stocks are relatively expensive over long periods, higher prices do not affect their long-term performance. 
Candriam is able to combine the quality and low-vol approach because of its unique mix of skills – deep fundamental analysis on the one hand, and on the other hand quantitative expertise to continually refine and improve our smart beta techniques. This allows us to optimise our positions and anticipate problems through a forward-looking approach. Although some investment firms do run pure smart beta strategies, we think most investors prefer a pilot in the cockpit rather than a computer flying solo.

Is now a good time to invest in the strategy? And who should invest?

Low volatility investing is attractive for equity investors who are worried about rising volatility in markets as central banks continue to intervene and currencies fluctuate. It is equally attractive to bond investors seeking higher yields. With many bonds producing low, or even negative, yields and spreads tight on corporate bonds, low volatility equities offer an alternative source of return. They effectively arbitrage equities and bonds, providing equity-like returns without the full volatility of equities. 
By avoiding the disadvantages of a cap-weighted portfolio, our combined portfolio is expected to have a higher Sharpe Ratio than other standard equity investments. The strategy is likely to suit investors who care most about the absolute risk-return characteristics of their portfolio irrespective of the market indices. Therefore, interest comes from pension funds, insurance companies and retail and private investors.