Smart Beta Indexes Fall Short of Factor Investing

Smart beta indexes may not provide true exposure to factors, according to research from Robeco Asset Management.

While the amount of exposure indexes provide differs “considerably,” none of the most popular strategies “unlock the full potential offered by factor premiums,” argued David Blitz, head of quantitative equity research at Robeco.

“Many smart beta strategies do not offer maximum factor exposure, but still contain a significant amount of market index exposure as well, or some unexpected exposures to other factors,” he wrote.

“Many smart beta strategies… still contain a significant amount of market index exposure as well, or some unexpected exposures to other factors.”For the study, Blitz compared value, momentum, low-volatility, profitability, and investment factor portfolios with corresponding Russell, S&P, and MSCI smart beta indexes. Though most of the indexes were “quite suitable” for obtaining factor exposure, they “fall short of offering maximum exposure to these factors,” he wrote.

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The Russell 1000 Value index, for example, carried only a 36% exposure to the value factor. Meanwhile, it was exposed 23% to the market, 21% to the investment factor, and 20% to the low-volatility factor.

“The Russell 1000 Value index provides highly diffuse factor exposures, and that is not very suitable for investors seeking pure and sizeable exposure to the value factor,” Blitz argued.

MSCI’s value-weighted index, on the other hand, offered more pure value exposure than its Russell counterpart—but its market exposure was 60%.

Even momentum and low-volatility indexes from MSCI and S&P, respectively, which offered among the highest exposures to their designated factors, remained more correlated to the market than pure factor portfolios.

“Altogether, these results imply that smart beta indexes may be used to harvest generic factor premiums, but also that it is crucial to properly understand the characteristics of these indexes in order to get the intended factor exposures,” Blitz concluded.

Read the full paper, “Factor Investing with Smart Beta Indices”.

Related: Smart Beta vs. the Monkeys

More than half of endowments and foundations have adopted or are considering impact investing, according to NEPC.

In a survey, the consulting firm found that 28% of endowments and foundations currently utilize impact investing strategies. An additional 25% said they plan to review a socially responsible investment program.

“We’ve seen client interest in the space grow significantly in the past five years and we expect the same growth for the foreseeable future,” said Kristine Butler, a senior consultant in NEPC’s endowments and foundations practice.

Nearly all of those who had implemented impact investing said the approach was aligned with their institution’s mission. Other reasons included encouragement from constituents and a belief that the approach could result in better risk-adjusted returns.

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“We’re seeing that the move to impact investing is most frequently motivated by positive pull factors like strong returns and mission alignment, as opposed to push from an institution’s key constituents, such as a board of directors or student body,” Butler said.

Rather than divesting from assets currently in their portfolios, these endowments and foundations said they focused primarily on making mission-related investments. Environmental, social, and governance issues were also highlighted as an area of focus.

Most impact investors (86%) said they expected the strategy to perform equal to or better than the overall market. However, not all respondents saw potential for outperformance.

Half of the endowments and foundations without impact investing strategies in place said they believed the approach could be a headwind to performance because it limits the investable universe. An additional 48% had “mixed thoughts.”

But investors “don’t have to sacrifice returns in order to have a principled investment strategy,” Butler said.

“It’s important the asset owner community understands that impact investing is based on more than merit alone,” she concluded. “The assets, be they in equities or fixed income, must align with the strategic framework of a risk-adjusted portfolio.”

nepc impact investing Source: NEPC’s “Q1 2016 Endowment and Foundation Market Survey”