Factoring in smart beta to combat volatility

Investors have plenty of options to manage market volatility but diversification remains the key.

Market volatility is back, driven this time by ongoing likelihood of pandemic-related supply chain disruptions sustaining inflation and bringing forward a long-expected rise in official interest rates.

Volatility, it seems, is here for a while, with investors’ concerns magnified by the already stretched valuations for risk assets. Share indices are at or near record highs - as are prices for most asset classes - fueled by emergency low official interest rates. With continuing speculation about whether a rash of pandemic-fueled inflation – with US annualised inflation hitting a 41 year high of 6.8 per cent in November - will prompt rising interest rates, markets appear set for a period of volatility. The rising risks have prompted some investors to question whether it is time to take some wins off the table or some insurance against volatility.

For most investors, diversification remains the best protection against volatility, according to Blair Modica, Director, Adviser Business at BetaShares. But there is also increased interest in factor-based or smart beta investing – which uses alternative index construction tools, rather than the traditional market capitalisation approach of passive investing - to manage volatility.

“There is a push from investors to smooth the ride, with the COVID impact on markets and lots of volatility creeping into performance. Investors are seeing volatility in their portfolio and want something that they can use as an investment strategy to counter it,” he says.

“It is particularly appealing to people who are approaching retirement and drawing down on their retirement savings as they want to try and avoid big swings in the market through volatility.”

Diversification provides insurance

A classical portfolio is built around the simple diversification of equities and fixed income, with 60% in shares and 40% bonds, based on the history of bonds rising when equities fall and vice versa. But with interest rates at emergency lows and 10-year Australian government bonds yielding around 1.5%, some investors have been concerned not to surrender too much growth by switching funds into low-yielding assets.

A diversification strategy can include spreading investments over a wider range of assets such as international, emerging market and domestic shares, real estate, infrastructure, private debt, and other alternatives. But many of these assets can be difficult and/or expensive for retail investors to access, Modica says.

Within specific markets and asset classes investors can also target investments with different characteristics, such as value stocks versus growth stocks, or industrial classifications such as property, financials, resources or retailers in the listed market to capture performance as different sectors come in and out of favour.

A bridge between passive and active management

Among managed funds and exchange traded products there has also been significant growth in so-called smart beta or factor investing, with funds created to screen particular investment factors or attributes. According to Van Eck the market has grown from around 10% of a much smaller ETF market in 2016 to more than 20% of a market worth $126.9 billion at the end of October. Interest in smart beta funds has surged as a low-cost alternative to high fee actively managed funds which have failed to consistently beat their benchmarks, according to VanEck.

 In the US there are 1210 smart beta ETFs, with US$1.66 trillion in total assets under management, according to ETF.com. Annual inflows to all US ETFs topped US$816 billion of net inflows by the first week of December1, with smart beta funds among the main beneficiaries, etf.com reported.

In the world of exchange traded funds (ETFs) it is sometimes known as ETF 1.5: a halfway house between passive index-based ETFs (ETF 1.0) and active or thematic ETFs (ETF 2.0) that have a higher degree of manager intervention in selecting stocks and correspondingly higher fees.

Smart beta uses alternative index construction tools to deliver market returns (beta) that track the index while providing a better investment outcome, such as smaller falls in value during a downturn. The first iterations of ETFs were designed to track a given index – such as the S&P 500 – and deliver retail investors that return in a liquid, accessible vehicle. As the indices are usually market capitalisation based, the more valuable the company, the higher its weighting in the index. It means the performance of the larger companies has an outsized impact on the fund’s performance. For instance, in Australia, the top 5 stocks account for nearly 30 per cent of the ASX 200 index.

Modica says that as a half-way house between index and active management, smart beta uses the index as a reference but applies different measures to construct the index to achieve a given objective. For example, an equal weight smart beta fund applies an equal weight to each company in the index, reducing the impact of larger capitalisation stocks that have an outsized influence on returns and magnifying the influence of smaller stocks, whose performance is usually swamped by the larger capitalisation companies. 

That reduces the influence of Commonwealth Bank of Australia, CSL, BHP, National Australia Bank and Westpac in Van Eck’s Australian Equal Weight ETF (ASX: MVW), which delivered annual returns of 10.01% since inception, against 8.38% for the S&P/ASX 200 Accumulation Index.

Screening investments for attractive factors

An equal weight ETF is just one of several smart beta strategies that have been developed to fill the gap between low-cost passive investment and high-cost active managers. There are smart beta offerings designed around value stocks, growth stocks, momentum, quality, fundamentals, dividends, environmental, social and governance factors, low volatility, and risk-weighting.

They can be designed to deliver low volatility – such as Blackrock’s iShares Edge Minimum Volatility ETFs (ASX: MVOL, WVOL), which replace the standard 60 per cent equity component of a portfolio with a low-volatility version of the MSCI world or Australian share indices to reduce volatility, lift performance and lower the maximum drawdown of the portfolio. Its top holdings include Telstra, Commonwealth Bank of Australia, Wesfarmers, CSL and Woolworths.

Chesler says low volatility strategies are not a big market in Australia, with the MVOL ETF holding around $220 million in early December, as investors preferred passive index funds or other ETFs focused on factors such as dividends.

Lower volatility as a bonus

But low volatility can also be a consequence of selecting stocks for other characteristics, according to Russel Chesler, Head of Investments and Capital Markets at VanEck Australia. For example, the Van Eck MSCI International Quality ETF (ASX: QUAL) screens 1500 stocks in the MSCI World ex-Australia Index for “quality” factors, including high return on equity, stable year-on-year earnings growth and low financial leverage. It, too, has outperformed the broader index and delivers substantially smaller drawdowns in a market downturn.

QUAL was the first smart beta ETF launched in Australia and was capitalised at around $2.8 billion in early mid-December. Trading data from AUSIEX for September, October and November 2021 shows QUAL consistently around the middle of the top 10 most traded ETFs.

“It tends to happen in markets that are not heavily leveraged,” Chesler says of the constancy of QUAL’s performance. “It underperformed ahead of the GFC when there was a lot of leverage in the market, but in a mid-cycle market where you are seeing a contraction in the economy, it has tended to outperform.

"While it is not technically a ‘low volatility’ factor ETF, when the market falls, QUAL has historically had a lower drawdown and recovered more quickly than the general market.”

BetaShares’ Global Quality Leaders ETF (ASX: QLTY) selects stocks based on return on equity, debt-to-capital, cashflow generation and earnings stability from the iSTOXX MUTB Global Ex-Australian Quality Leaders Index. Its $242 million in assets is invested across technology, healthcare and industrials, with lesser weightings to financial, communication and consumer staple stocks.

Investors spread their risks

The AUSIEX data show trading is dominated by passive index funds such as those tracking the S&P ASX 200, the S&P 500 and the Nasdaq indices, with occasional breakouts by hot thematic funds such as BetaShares’ Crypto Innovators ETF (ASX: CRYP), ETF Securities Hydrogen ETF (ASX: HGEN) and Battery Tech & Lithium ETF (ASX: ACDC). That may suggest investors are choosing their own diversification within broad index-based investing.

BetaShares’ Modica says that smart beta is just one tool that investors can use to lower volatility in a portfolio. But the key remains diversification, including holding ETFs that focus on distinct factors.

“It may not mean outperformance, but they are intended to avoid the wilder swings and drawdowns of the overall market,” he says.

1 ETFs Cross $800B Inflow Mark | ETF.com