Smart beta and factor investing A look ‘under the hood’ September 2014 Tim Matthews | Client Portfolio Manager For professional investors and advisers only What is ‘smart beta’? Smart beta is like an old fashioned car 1 What is ‘smart beta’? Smart beta is like an old fashioned car 2 What is ‘smart beta’? An alternative to cap weighted benchmarks Smart beta/alternative beta/strategic beta/harvesting risk premiums Transparent, rules based strategies Generally use a non-market capitalisation approach Target characteristics that are expected to add value or reduce risk in the long run Source: Schroders 3 Cap weighting is anti-value Buy and hold strategy unable to trade out of expensive into cheap Growth of $100 in various smart beta strategies – cumulative return 1,200 1,000 800 600 400 200 0 1988 1989 1990 1991 1992 1993 1994 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2009 2010 2011 2012 2013 MSCI World: Fundamental Weighted MSCI World: Equal Weighted MSCI World: Minimum Volatility MSCI World Source: Schroders, Worldscope, MSCI. All returns are in USD (gross) and portfolios are rebalanced twice a year, 1988 – 2013. Every 6 months we take the MSCI World constituent stocks and calculate; Equal weighted portfolio returns using all stocks in the index. Fundamental Weighted which uses all stocks in the index but weights them according to the following fundamental factors (Sales, Cash Flows, Earnings, Dividends and Book). Minimum Volatility uses the MSCI minimum volatility index. 4 Rebalancing as an additional source of return Importance of rebalancing Regular rebalancing adds value, even if criteria used has no economic basis 900 800 700 600 500 400 300 200 100 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 MSCI World Source: Schroders, 28 February 2014 5 MSCI World: Equal Weighted MSCI World: Reweighted by Length of Company Name Smart beta: pros and cons Value tilted Diversified by stock, sector and country Breadth and efficient use of universe Targets specific stock characteristics Opportunity rebalanced Actively risk managed Source: Schroders 6 Passive Smart Beta Anti-value bias due to lack of automated rebalancing Not targeted but breaks price link to weights to help value Can concentrate in stocks, sectors, countries or themes. Bubbles are exaggerated. Can concentrate in sectors, countries or themes because of focus on simple stock characteristics Whilst some broader indices exist they still squeeze out mid-capitalization stocks Often restricted to large-cap universe, construction method can squeeze out midcapitalization stocks Aside from "Size", stock characteristics are not taken into account Most Smart Beta strategies include some active tilt to a specific stock characteristic Stocks are added/deleted when stocks reach minimum size and done on set days Arbitrary/infrequent rebalancing (usually 2 or 4 times a year) Strategies often have stock, sector or country restrictions but these are often expressed relative to a cap weighted index 6 Smart beta 2.0 The car is better – it does the job needed 7 Smart beta 2.0 Refining the principle – What is it and how has it evolved? March 2013 – French EDHEC Risk Institute investigated inefficiencies of 'traditional' smart beta According to EDHEC, inherently simplistic weighting methods lead to unintended risk exposures Smart Beta 2.0 – different approach for measuring and managing unintended 'specific' risks to include stock selection before weights established Suggests filtering stocks for liquidity to avoid liquidity risk, and forcing sector neutrality to avoid unintended sector weights Source: EDHEC Risk Institute, March 2013 8 Schroders strategies: A top end car Model-driven stock selection and portfolio construction 9 Schroders strategies: A top end car Model-driven stock selection and portfolio construction Schroders began to research factor risk premia investing in the mid-1990s The team manages USD 45 billion across 7 strategies Highly diversified (400+ stocks) across small, mid and large-cap Stock selection based on a large number of fundamental factors “Bottom-up” portfolio construction 10 Schroders and smart beta Above and beyond Smart Beta 2.0 However, we also address limitations of “traditional” smart beta by: – Industry relevant factors – Risk-managed portfolio construction – Up to daily rebalancing if economically useful – Forward-looking research to identify changes in the fundamental drivers of stock return 11 Composition of return Added value of active management (“Alpha”) Return Schroders manage portfolios in spirit of Smart Beta 2.0: – Stocks are assigned scores based on multiple metrics to arrive at a final score for “Value” or “Quality” etc. – Concerns about liquidity are addressed Factor premium (via Smart Beta Indices) Market return or Beta (via investing in “naive” benchmarks) Final score card Is ‘Smart beta’ better described as ‘Dumb alpha’ or ‘Smart marketing’? Passive Value tilted Diversified by stock, sector and country Smart Beta Anti-value bias due to lack of automated Not targeted but breaks link to share rebalancing price which introduces a value exposure Schroders: A better solution Rebalancing back to non-market cap stock weights Can concentrate in stocks, sectors, countries or themes. Bubbles exaggerated Can concentrate in sectors, countries or themes Diversifies across stocks, sectors, countries or themes by construction Breadth and efficient use of universe Whilst some broader indices exist, still squeeze out mid-capitalisation stocks Often restricted to large-cap universe Exploits global universe of 15,000+ stocks Targets specific stock characteristics Aside from “size", stock characteristics are not taken into account Most strategies include some active tilt to a specific stock characteristic Stock selection focused on Value and Quality Stocks are added/deleted when they reach minimum size and on set days Arbitrary/infrequent rebalancing (usually 2 or 4 times a year) Rebalanced by the opportunity set available and recent fund performance Strategies have stock, sector or country restrictions Risk management implemented by FM’s on a forward looking basis Opportunity rebalanced Actively risk managed Source: Schroders 12 Conclusion Benefits for end clients Strategies managed in this more intuitive way are highly suitable for investors looking for: – Specific factor exposure without unexpected contributions from other factors – Diversification and opportunities from stocks of large and small companies – Experienced team with proven added value and excellent infrastructure Time Horizon For illustrative purposes only 13 Schroders strategies Smart beta Appendix Introducing the QEP Investment Team An experienced and well-established team $45.1bn 14YR TRACK RECORD ASSETS UNDER MANAGEMENT 28 JUSTIN ABERCROMBIE Head of QEP Investment Team 21 years of experience; set up team in 1996 STAFF in LONDON, SYDNEY AND NEW YORK 7 CLIENTS IN 25+ GLOBAL/INTERNATIONAL STRATEGIES MARKETS Source: Schroders, QEP. Assets as of June 30, 2014. Team information is at end August 2014 15 Schroders QEP an alternative to passive management Return and risk attractive Strategy Global Core Global Value Inception Assets January 2000 €6.7bn October 2004 €8.4bn Description Repeatable outperformance with low index relative risk Global Value Plus Relative Total (%) 1.2 Tracking Error Information Ratio 1.1 1.1 3.6 0.4 5.4 1.2 3.4 1.0 2.2 1.2 2.7 1.3 19.3 Target index + 1% p.a. Global unconstrained value strategy. High return potential with low stock specific risk 1.5 23.9 Target index + 3% p.a. Global unconstrained value strategy July 2008 €388m Relative p.a. (%) 6.5 150% long Value up to 50% short low Quality 56.1 Target index + 5% p.a. Global Quality Global Blend Emerging Markets October 2007 €6.0bn September 2008 €5.1bn March 2012 €1.6bn Quality strategy (Profitability, Stability and Financial Strength) with lower beta than the market 3.4 25.6 Target index + 3% p.a. Blend strategy combines a balanced approach to Value and Quality in a single strategy 2.6 20.9 Target index + 3% p.a. EM strategy combines a balanced approach to Value and Quality in a single strategy 3.5 6.4 Target index + 3% p.a. Source: Schroders – Performance represents QEP composites, gross of fees in EUR terms, as at 31 March 2014. Relative performance for Core is MSCI World, EM is MSCI EM, Global ex US Value is MSCI AC World ex US, and remaining are MSCI AC World Net Dividends Re-Invested (NDR). Please refer to the inception dates in table for starting dates A GIPS presentation of composite performance is available on request 16 Important information The views and opinions contained herein are those of Tim Matthews, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds This presentation is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions Third party data is owned or licensed by the data provider and may not be reproduced or extracted and used for any other purpose without the data provider's consent. Third party data is provided without any warranties of any kind. The data provider and issuer of the document shall have no liability in connection with the third party data. The Prospectus and/or www.schroders.com contains additional disclaimers which apply to the third party data Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored 17
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