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Smarter Beta

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Ruben FalkGlobal HeadInvestment Management SegmentS&P Global Market Intelligence

September 2016

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Defining Smart Beta

2

• “Smart beta” can be defined as strategies that differ from the traditional market capitalization-weighted method in search of better risk-adjusted returns through exposures to desirable characteristic or factors

• These factor-based strategies are not new to investors– Quantitative managers have long been using computer-driven algorithms to exploit inefficiencies and investor behavior

biases in the stock market (e.g., value, size, momentum, quality, volatility, etc.)

– However, investors usually gain exposures to these factors through active managers

• Smart-beta approach provides investors with accessible tools to systematically harvest factor-based premiums at a lower cost. Investors now only need to hire active managers where they have been shown to provide alpha beyond the static-factor exposures

– “For an average active manager, static exposures to four smart beta factors (market, size, value, and momentum) explain about 35% of their active risk budget. . . . for about 35% of these managers, smart beta contributes 50% or more of their active risk.” – Smart Beta: The owner’s manual, Kahn and Lemmon

• According to a report released by Invesco, the smart beta ETF category is poised for the greatest growth relative to all other ETF categories over the next three years, with more than half (53%) of institutional decision-makers expecting to increase their use of smart beta ETFs

Source: Market Strategies International Research Report, Invesco PowerShares Capital Management LLC (January 2015) The Evolution of Smart Beta ETFs | Gaining Traction in the Institutional Community.

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Smart Beta amongst Global Asset Owners

3

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

AUM>$10BN AUM$1-10BN

SmartBetaAllocationsofGlobalAssetOwners

HaveSmartBetaAllocation CurrentlyEvaluatingSmartBeta Other

Combined 64% in 2016, up from 46% in 2015

Source: “Smart beta: 2016 global survey findings from asset owners”, FTSE Russell

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Smart Beta Market

4

A recent research paper by Denys Glushkov shows that dividend, equal-weighted, and multi-factor-based strategies lead the smart beta (SB) in market share

Source: “How smart are “smart beta” ETFs?” Denys Glushkov, University of Pennsylvania 2015.

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A Simple Smart Beta Example

5

The rationale behind the smart beta idea is illustrated using the simple factor, earnings-price (E/P) ratio, by building five portfolios using various weighting schemes and observing the difference in performance

Source: S&P Global Market Intelligence’s Quantamental Research as of 1 Sep. 2016. S&P 1500 index from January 1995 – Sep 2016. Quarterly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

0200400600800

100012001400160018002000

TotalR

eturnInde

x

PerformanceofEarningsBasedWeightingSchemesrelativetotheS&P1500Benchmark

TopE/PQuintileEqualWeight

TopE/PQuintileCapWeight

EarningsWeighted

BenchmarkEqualWeight

BenchmarkCapWeight

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Smart Beta, Dumb Beta

6

• Smart beta strategies have received criticism from both academics and practitioners– Many do not believe they are “smart” because long-run factor performance is no better than cap-

weighted benchmarks

– They would be better described as ‘factor indices’ or ‘strategic beta’ as they are just a systematic exposure to style factors

• Fama-French factors have been published for many years– There are also concerns that “crowding” of these factors causes opportunities to be

arbitraged away

• Evidence also shows factor performance can fluctuate over time, begging the question of how to create more stable strategies

• Some strategies do not work during certain macro and market regimes– But factor timing is difficult (e.g. Asness, 2016)

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A Closer Look At Factor Choice

7

• Each style represents an investment theme– Fama-French started with basic ideas such as price-to-book, but there are many others that can be

used to measure the value of stocks relative to their fundamentals

• E.g., U.S. and other Developed Market investors tend to focus more on cash flows– As a result, Cash flow-based factors have better-observed returns than earnings based-factors. Using

the free cash flow to price factor, we are able to obtain higher returns relative to earnings-to-price

Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 & 9 Sep. 2016. S&P 1500 and BMI EAFE indices from Jan. 1990 – Sep. 2016. Monthly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

S&P1500,TopQuintile,EqualWeight BMIEAFE,TopQuintile,EqualWeight

CumulativeAc

tiveRe

turn(%

)

CumulativeAc

tiveRe

turn(%

)

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S&P Capital IQ Alpha Factor Library Style Definition

8

To avoid biases from factor selection, we built eight style indicators to provide a comprehensive view of style performance. Then we track factor performance based on equal weighted quintile returns.

Source: S&P Global Market Intelligence’s Quantamental Research, as of 1 June 2015.

Quantamental Style Indicators

Valuation Historical GrowthBook to Price

Under-valued companies measured by book value, sales, earnings, cash flow and

dividend yield

1Y Chg FCF/Assets

Companies that have strong YoY growth in Earnings, Cash Flow, and Assets

FCF/Price 1Y Chg OCF/AssetsEBITDA/EV 1Y Chg Sales TurnoverE/P 1Y Chg EPSDiv/Price Sustainable GrowthSales/EV

Earnings Quality Capital EfficiencyCash Conversion Cycle

Companies with strong management quality and healthy earnings

Return on EquityCompanies that try to maximize shareholder

value by optimizing capital structure and return on capital

Net Profit Margin CF ROICWC Accruals LT Debt to EquityAccrual Ratio - CF Capital Acquisition RatioNet Income Stability 1Y Chg Shares Out

Price Momentum Analyst Expectation12M - 1M Price Mom

Companies that are chased by investors for strong long-term outperformance and short-

term rebounds

Long Term GrowthCompanies liked or disliked by analysts that

follow the stock1M Price Reversal Analyst Diffusion1M Price High Low SUE9M Price Momentum Num FY1 EPS Rev5D Price Reversal

Volatility Size12M Realized Volatility

Companies that have higher price fluctuations, generally considered as

technically risky

Companies that are relatively smaller, generally considered as fundamentally risky

1MVol Log Market Cap60M CAPM Beta Log TTM Sales90DCV

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Factor Premium – Valuation

9

Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 Sep. 2016. BMI global index except for U.S. (S&P 500), China (S&P CITIC 300), Australia (S&P/ASX 200), Canada (S&P/TSX), last 10 years, Q1 active cap-weighted, monthly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Last 10 Years

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Factor Premium – Growth

10

Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 Sep. 2016. BMI global index except for U.S. (S&P 500), China (S&P CITIC 300), Australia (S&P/ASX 200), Canada (S&P/TSX), last 10 years, Q1 active cap-weighted, monthly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Last 10 Years

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Factor Premium – Earnings Quality

11

Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 Sep. 2016. BMI global index except for U.S. (S&P 500), China (S&P CITIC 300), Australia (S&P/ASX 200), Canada (S&P/TSX), last 10 years, Q1 active cap-weighted, monthly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Last 10 Years

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Factor Premium – Capital Efficiency

12

Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 Sep. 2016. BMI global index except for U.S. (S&P 500), China (S&P CITIC 300), Australia (S&P/ASX 200), Canada (S&P/TSX), last 10 years, Q1 active cap-weighted, monthly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Last 10 Years

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Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 Sep. 2016. BMI global index except for US(S&P 500), China(S&P CITIC 300), Australia(ASX 200), Canada(TSX), Last 10 Years, Q1 Active Cap Weighted, Monthly Rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Factor Premium – Price MomentumLast 10 Years

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Factor Premium – Low Volatility

14

Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 Sep. 2016. BMI global index except for U.S. (S&P 500), China (S&P CITIC 300), Australia (S&P/ASX 200), Canada (S&P/TSX), last 10 years, Q1 active cap-weighted, monthly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Low volatility is more pronounced after financial crisisLast 5 Years

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Multi-Factor Approach

15

A multi-factor approach typically improves single-factor performance by allowing strategies that work independently to reduce return volatility

Source: S&P Global Market Intelligence’s Quantamental Research, as of 2 Sep. 2016. S&P 1500 index from Jan. 1995 – Sep. 2016. Quarterly rebalancing. For the above exhibits, back-tested returns do not represent actual trading results and were constructed with the benefit of hindsight. Returns do not include payments of any sales charges or fees. Such costs would lower performance. Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

• Smart Beta is all about positioning

• A few ideas that could resonatewith investors:

– Profitability + Valuation =Quality at a Reasonable Price

– Valuation + Growth =Growth at a Reasonable Price

– Momentum + Valuation =Value with a Catalyst

– Cash Flow + Valuation =Cash Generation at a Reasonable Price

– Cash Flow + Momentum =Cash Generation with a Catalyst

0

500

1000

1500

2000

2500

3000

TotalR

eturnInde

x

PerformanceofTwoFactorCombinationrelativetotheS&P1500Benchmark

E/P&ROIC,Top100,EW

ROIC,Top100,EW

E/P,Top100,EW

BenchmarkEqualWeight

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PortfolioConstruction

16

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Smart Beta Portfolio Construction Approaches

17

Alpha or Smart Beta Signals

Portfolio Construction

Rules Based

Optimization Based

Risk Mitigation/ Neutralization- Sector/Country- Factor Loading- Tracking Error

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Examples Of Rules Based Strategies

18

(S&P 1500, Jan. 1995 – Sep. 2016)

0%

5%

10%

15%

20%

S&P 1500 CW

S&P 1500 EW

Earnings Weighted

E/P (Top 100) CW

E/P (Top 100) EW

ROIC (Top 100) CW

ROIC (Top 100) EW

E/P & ROIC (Top 100)

CW

E/P & ROIC (Top 100)

EW

9.7% 11.9% 10.5% 12.6% 14.5% 13.2% 15.2% 15.0% 16.1%

0.51 0.59 0.57 0.50 0.58 0.69 0.76 0.72 0.74

Source: S&P Global Market Intelligence, ClariFI information 1 Jan. 1995 to 1 Sep. 2016. Quarterly rebalancing. For illustrative purposes only. Note: Past performance is not an indication of future results. Indexes are unmanaged, statistical composites and it is not possible to invest directly in an index. These results are inherently limited because they do not represent the results of actual trading and were constructed with the benefit of hindsight. The returns shown do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and back tested performance to be lower than the performance shown.

Annualized returns

Sharpe Ratio

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Example Of An Optimization Based Strategy

19

• Objective at each quarterly rebalancing: Maximize portfolio weighted two-factor model score (E/P and ROIC) subject to the following set of constraints

– Exactly 100 holdings, fully invested– Maximum 60% annual one-way turnover

– Maximum trade size of 30% of average daily volume given a starting capital of$500 million

– Maximum 9% tracking error– No single holding less than 0.25% of the portfolio– Holding size

§ Maximum 3% of portfolio, or§ Maximum 5 times benchmark weight (B*5)

Note: Tracking error is defined as the annualized standard deviation of the active (excess) portfolio returns relative to the benchmark

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Source: S&P Global Market Intelligence, ClariFI test dates 1 Jan, 1995 to 1 Sep. 2016. For illustrative purposes only. Note: Past performance is not an indication of future results. Indexes are unmanaged, statistical composites and it is not possible to invest directly in an index. These results are inherently limited because they do not represent the results of actual trading and were constructed with the benefit of hindsight. The returns shown do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and back tested performance to be lower than the performance shown. Turnover is one-way.

Optimized Portfolio Results

E/P & ROIC 2-Factor ModelConstrained Optimization

S&P 1500 UniverseJan. 1995 – Sep. 2016

Sharpe Ratio

Annual Return

Tracking Error

Annual Turnover

Avg. P/E

Avg. ROIC

Avg. Mkt. Cap.($B)

Top 100, Max 3% Holding Size 0.61 12.7% 7.2% 55% 10.7 27.9% 27.7

Top 100, Max B*5 Holding Size 0.64 12.2% 6.0% 56% 12.6 25.1% 115.4

Benchmark (S&P 1500 Cap. Weighted) 0.51 9.7% - - 17.6 15.6% 79.5

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Risk Factor Neutralization –Equity Risk Model From S&P Global Market Intelligence

21

Style Factor Number of Constituent Indicators Constituent Indicator Highlights

Analyst Expectation 11

• Earnings & Sales Forecast• Earnings Surprise• Analyst Diffusion• Analyst Revision

Capital Efficiency 10• Return on Equity & Capital• Leverage & Interest Coverage • Issuance & Buybacks

Earnings Quality 26

• Balance Sheet Accruals• Working Capital & Asset Turnover• Capital Expenditure and R&D Intensity• Margins, Payout Ratio

Historical Growth 31

• 1 & 3-year growth of- Operating & Free Cash Flow- Earnings- Margins

Price Momentum 20• 1, 6, 9 & 12-month Price Momentum• Technical indicators over various time frames• MACD, RSI, Slope, 52 Week High/Low

Size 2 • Log of Market Cap. & Sales

Valuation 34

• Reported & Forward Earnings Yield • Dividend Yield• Book to Price Sales, EBITDA & Cash Flow to Enterprise Value• Inverse PEGY

Volatility 9

• Realized volatility • CAPM Beta • Distance from High to Low (1 & 12 months) • Short Interest & Trading Volume

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Risk Factor Neutralization And Tilts – Example

22

-0.10 0.20 0.30 0.40 0.50 0.60 0.70

Top 100, Max 3% Holding

Size

Top 100, Max B*5 Holding

Size

Benchmark (S&P 1500

Cap. Weighted)

Sharpe Ratio

Optimized Base Case

Optimized Factor Neutral/Tilt 0%

2%4%6%8%

10%12%14%

Top 100, Max 3% Holding

Size

Top 100, Max B*5 Holding

Size

Benchmark (S&P 1500

Cap. Weighted)

Annual Return

Source: S&P Global Market Intelligence’s, ClariFI test dates 1 Jan. 1995 to 1 Sep. 2016. For illustrative purposes only. Note: Past performance is not an indication of future results. Indexes are unmanaged, statistical composites and it is not possible to invest directly in an index. These results are inherently limited because they do not represent the results of actual trading and were constructed with the benefit of hindsight. The returns shown do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and back tested performance to be lower than the performance shown.

Style Factor Benchmark Relative StanceMarket Beta Neutral

Historical Growth Neutral

Valuation Positive

Capital Efficiency Positive

Earnings Quality Positive

12.7% 12.6% 12.2%

10.4%9.4%

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Concluding Thoughts

23

• Avoid pitfalls of data mining– Use economic intuition

– Check that the strategy is deriving returns (and risk) from intended exposures

• Combine complementary factors, e.g.– Value & Quality/Capital Efficiency

– Momentum & Capacity Utilization [Aretz & Pope, 2015]

• Analyze investability with respect to liquidity, turnover, and transactioncosts/market impact

• Identify methods of risk control, e.g. risk model based vs. sector/country constraints

• Rules based vs. optimization based portfolio construction– Tradeoff between transparency and flexibility

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Q&A

24

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Reference Addendum

25

Market Strategies International Research ReportInvesco PowerShares Capital Management LLC (January 2015)The Evolution of Smart Beta ETFs | Gaining Traction in the Institutional Community

How smart are “smart beta” ETFs?Denys Glushkov, University of Pennsylvania, 2015

Smart Beta: The Owner’s ManualKahn and Lemmon, Journal of Portfolio Management 2015

Excess Capacity, Momentum, and Long-Term ReversalsAretz and Pope 2015

The Siren Song of Factor TimingAsness 2016

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