In January 2014, Russell Indexes conducted a survey of equity investment decision makers from almost 200 asset owners across North America, Europe and the Middle East to better understand perceptions of smart beta. In the survey we found that the greatest unmet need from asset owners was for the ability to use smart beta indices to control their exposures.

Defining smart beta

Smart beta happens to be a narrow term that is often used to define a broad range of investment strategies. At Russell, we generally break these strategies down into two types of exposures. The first type is ‘strategy-based’ and the second is ‘factor-based’. Strategy-based smart beta exposures have seen a lot of popularity over the past few years and are typically non-cap weighted, with an emphasis on the strategy’s ability to outperform a traditional cap-weighted benchmark. Factor-based smart betas on the other hand are designed to provide exposure to a segment of the market that displays similar factor characteristics (i.e. value, momentum) and asset owners that are looking to manage their exposures more explicitly typically look to factor-based solutions.

Smart Beta - Types of exposures

When comparing strategy-based and factor-based portfolios, there are similar characteristics and exposures between the two. For example, the return stream from a strategy-based minimum variance portfolio is similar to the return stream from a factor-based low volatility portfolio. An equal-weight index has small cap exposure, but is not specifically focused on the small cap factor. Likewise, fundamental indexing has a value exposure, but is not specifically focused on capturing that factor.

Investors need to take into consideration the similarity in both exposures and returns between specific strategy-based and factor-based portfolios in their assessment of the most appropriate solution.

Providing the relevant tools

In response to the need to more explicitly control portfolio exposures we launched the Russell High Efficiency™ Factor Index (HEFI) series. In developing the HEFI series, our focus was on identifying equity market factors that were relevant, comprehensive, universally robust, persistent and implementable. The consistent methodology utilised across the HEFI series offers an advantage to investors who are looking to control and manage exposures and effectively combine their smart beta allocations with traditional active strategies. The factors we have focused on – value, momentum, quality and low volatility are the four primary drivers of active equity returns.

At Russell, we have developed six key requirements for effective exposure management that include:

•Using simple and robust factors.

•Putting factor exposure at the heart of index construction.

•Being active-risk aware.

•Keeping turnover at moderate levels without sacrificing intended exposures.
Having a high capacity in terms of sensible turnover rules and appropriate banding rules.

•Using consistent portfolio constructs that are modular and consistent in order to complement one another.

Three types of smart beta usage

We believe that smart beta exposures, whether they are strategy or factor-based, can serve as a strong complement to an active portfolio with the potential to enhance returns, help reduce portfolio risk and add diversification. The three key parts of our process where smart beta exposures are employed are:

Strategic
From a strategic point of view, we utilise smart beta strategies to position our portfolios in line with our long-term investment beliefs. For example, Russell believes there is a value premium in the market and when we construct our portfolios we want them to be biased towards value. We also believe that medium term momentum works well and that our portfolios should also have that same exposure.

Dynamic
The next approach is considering smart beta strategies from a more dynamic or tactical basis. Within our own portfolio construct we are increasingly more adaptive in how we position the portfolio through different market cycles. Although we have longer-term beliefs regarding the expected pay-off to different factor exposures, we recognise that over shorter-term horizons the interplay of the market cycle, valuations and sentiment can present opportunities to take advantage of market dislocations. We believe having smart beta exposures that allow us to adjust the portfolio to the changing market conditions, allows us to get the right exposure at the right time.

Risk Management
A third approach is to integrate active and passive allocations within the portfolio structure. For example, the portfolio could incorporate an exposure to smart beta strategies designed to complement the stance taken by the active managers as a whole. Russell research has shown that in general, active managers are overexposed to more volatile stocks, and what may appear to be a well diversified portfolio is actually overexposed to the volatility factor. Shifting a portion of the equity allocation to a defensive strategy can continue to provide the active management opportunities while potentially mitigating the unwanted exposure to volatility that may be introduced by active managers.

The complementary nature of the Russell HEFI series and the low correlation of active returns across the factors enable investors to build robust multi-factor portfolios. The ability to effectively combine factors within a portfolio has historically been limited to quantitative-based asset management firms. The Russell HEFI series brings many of these quantitative techniques and insights to investors in a modular framework which is easy to implement and manage.

For more information about Russell’s smart beta indices, visit www.smartbetaindices.com.

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