(May 1, 2014) — Smart beta works, according to three US-based researchers who wrote paper on investing via risk premia while working together at MSCI.
In “Can Alpha Be Captured by Risk Premia?” Jennifer Bender, P. Brett Hammond, and William Mok suggested investors can use smart beta strategies in their portfolios and outperform their peers who choose solely active managers.
“Using smart beta strategies that utilize risk premia factors can get institutional investors as much as 80% of the returns of pure active management,” the authors said, adding that blended strategies may be the best way to achieve an investor’s required result. “By preselecting risk premia that meet the institution’s investment goals, and then screening for active managers who achieve alpha beyond that generated by these risk premia strategies, you can achieve best risk-adjusted returns—and at lower cost.”
In effect, using smart beta strategies allow investors to lose the management they don’t need—nor want to pay for.
Additionally, investors should look for low correlation between passive and active, according to the paper. They need to identify alpha-producing (active) managers whose returns have low correlation with (passive) risk premia strategies, rather than pick equivalent managers with low alpha.
Despite risk premia investing being a popular topic within the academic community, theoretical research does not provide a framework for implementing the strategy, said Hammond, managing director for research at MSCI. Some of the world’s most sophisticated investors have adopted at least a partial risk-factor investment approach into their portfolio, but it has yet to take off more widely.
However, Hammond asserted that the approach isn’t “just a theory. There is solid practice as well.”
Using the eVestment database of US active managers over the 2002 to 2012 period, and comparing returns to those of the MSCI risk premia indices, the authors found two of the four risk premia outperform most active managers and three of the four risk premia show very similar or higher correlations with the active managers.
Examining the findings more closely, using the Fama-French model, they found risk premia accounts for more than half of the alpha generated by active managers.
The 80% claim, stated above, came through analysis of the MSCI USA Barra momentum index, which captures the performance of high- and low-momentum, long-only strategies.
The article provided a framework to choose active managers generating the highest alpha and blend them with risk premia indices in a portfolio.
“For example, an asset owner could decide to adopt one or more risk premia strategies and then review active managers by examining how much alpha they have added in addition to those risk premia strategies,” Hammond pointed out.
“That way, they get the benefit of both the active managers and the risk premia strategies without having to pay active fees for risk premia results.” Asset owners can also use this framework to examine how much value their current active managers are adding on top of risk premia indices, he added.
Here is the whole article, published by the Practical Applications section of the Institutional Investor Journals.
Bender is now managing director for research at State Street Global Advisors.
Related content:The Smart Beta Tragedy & Is this the End of Risk-Factor Investing? Or Only the Beginning?