Factor-based investing is smart beta done old school.
Today, most smart beta funds rely on a single index of equities weighed by one or more factors like value, momentum and volatility, while others, such as funds sub-advised by Austin, Texas-based Dimensional Fund Advisors, use factors to select and time stock trades.
Global X, a New York-based fund manager, has taken an entirely different approach—creating a bundle of indexes based on individual factors based on academic metrics, then combining those indexes into funds that encompass multiple factors and weighting approaches.
As a result, Global X’s Scientific Beta suite of ETFs addresses several shortcomings in many smart beta funds through strategies designed using research from the EDHEC-Risk Institute, a French financial research and education institution.
The suite of funds was designed to give investors geographic diversification; the funds represent markets in the U.S., Europe, Japan and Asia outside Japan.
While Dimensional Fund Advisors has been using factor-based investing supported by its founders’ research for more than 30 years, Jay Jacobs, director of research at Global X funds, traces the strategy’s history back farther than that.
“Factor investing goes back as far as Benjamin Graham and Warren Buffett and the other people who first identified the benefits of value stocks,” says Jacobs. “Our role in that history is being able to partner with Scientific Beta to bring a product that is best of breed from an academic perspective to clients in a tax-efficient, liquid investment vehicle.”
The concept is simple, says Eric Shirbini, global product specialist at EDHEC-Risk Institute’s Scientific Beta division in London—it is to create indexes that give investors exposure to market risk and returns, or beta, plus an additional risk premium.
“Academic research has shown that there are some risk premiums that provide a return over and above the market average,” Shirbini says. “By taking exposure to certain risks, you can get higher returns than the market. That’s what factor investing is all about.”
Global X’s indexes represent value, size, momentum and volatility premiums, all of which have produced returns over and above the market in academic research.
Shirbini says that it isn’t enough to choose factors based on rigorous academic research—the measures of those factors must match the measures used within the research.
“Academic research tends to use simple measures to determine whether there is a risk premium,” Shirbini says. “For example, with value Fama and French used book-to-market, one simple measure of value. With momentum, we use the 12 month price momentum measure that several researchers have used. With volatility, we look at volatility over the past two years." And for size, Scientific Beta selects stocks from the lowest to the highest market capitalization.
Using the S&P 500 as a starting point, within the Global X Scientific Beta U.S. ETF, the value index selects the lowest 250 stocks by price-to-book, the size index the smallest 250 stocks by market cap, the momentum index the highest 250 stocks by 12-month returns, and the low-volatility index the lowest 250 stocks by 104 week volatility.
“Sometimes we see people creating their own definitions for factors or focused on accessing factors without thinking about diversification,” Jacobs says. “It’s not just overall performance that we need to consider when designing products. It’s also risk-adjusted returns.”
After the stocks are selected, each index uses a multi-strategy weighting scheme to diversify and address potential concentration risks and other model-specific risks. The stocks are equal-weighted to minimize concentration, then volatility is minimized through decorrelation, risk weighting and the efficient maximum Sharpe ratio.
“We construct indexes that give you exposure to each one of these factors separately,” Shirbini says. “The final step in the process is to combine these four factors into one product and to create what we call a multi-factor index. These indexes are attractive because they smooth out the returns over time.”
Shirbini says turnover is limited because some of the trades that might be incurred by investing using a single-factor strategy end up being eliminated.
“The way we construct these multi-factor indexes gives you a great deal of transparency,” Shirbini says. “You can look at each individual component and understand your investment, which factor is working at which time. It makes the process easy to break down.”
While the EDHEC strategy might sound complicated, Shirbini says at heart it’s just a combination of simple measures working in tandem that should lead to smart beta’s end point: capturing the heart of the market’s positive performance while limiting risks.
That simplicity is key to the Global X products’ performance through volatility. At the end of March, the fund had generated three-month cumulative returns of 7 percent, compared with 1.35 percent for the S&P 500 index.
“What we often tend to see is when people try to implement value, momentum or volatility strategies, they tend to overcomplicate them and move away from the simple way they are defined in academia,” Shirbini says. “There is academic research that shows that as soon as you start to overthink a particular factor, you start to introduce more idiosyncratic risk, so the key is to be parsimonious. You should be able to identify it in a simple manner.”
Simplicity also minimizes fund expenses—Global X’s Scientific Beta U.S. ETF carries a 0.35 percent gross expense ratio, while the other three Scientific Beta ETFs have 0.38 percent in expenses - all the funds come with a fee waiver of 0.19 percent for a year.
“We think it’s a huge advantage to be able to match strategies based on academic research with the accessibility of ETFs,” Jacobs says. “For us, it comes down to the quality of the index itself. With smart beta, the quality of index construction becomes a more important aspect when you look at returns and risk-adjusted returns. We believe ERI Scientific Beta has come up with the most robust ideas in this space.”