Of course, low-volatility ETFs were designed in recent years to provide investors with both income and stability, and it’s quite possible they can continue to do so—only without the capital appreciation. “People have seen excess returns from low volatility over the last 15 years, but it’s not sustainable,” said roundtable participant Brent Leadbetter, vice president of client strategies at Research Affiliates.
Still, context is critical. Outcomes-based investing has served as a major theme at BlackRock, and Holly Framsted, a strategist on the iShares equity smart beta team who sat at the roundtable, said people shouldn’t be that surprised that most clients have increased their equity risk exposure in a low-growth, low-yield world. The more pertinent question is what problem they are trying to solve.
If clients want to remain in equities and lower their risk, minimum volatility ETFs can work, Framsted noted. It also has to be weighed against the potential unintended consequences of going into high yield, where clients could be getting equity-like risk without the upside of rising dividend income. “It’s not all about performance; it’s also about risk reduction,” she added.
What Smart Beta Needs
Nonetheless, smart beta needs a new next big thing. The search for other sources of return is one reason factor investing is enjoying a resurgence. Value, momentum, size and quality (or profitability) are among the strategies that smart beta strategists are revisiting.
Some are thinking outside the box and trying to blend smart beta with other strategies like risk parity, which focuses on the allocation of risk rather than capital. That lies behind the JP Morgan Diversified Return International Equity approach, in which avoiding overconcentration is a key goal.
Many investment strategies deliver most of their value by dodging big losses, said roundtable participant Nigel Emmett, managing director at J.P. Morgan Asset Management. Risk parity means, among other things, he doesn’t have to project returns but can zero in on risk levels in various sectors and asset classes. His fund seeks to equally allocate risk as measured by the Sharpe ratio, value, momentum, size and low volatility across 40 different regional sectors.
“It is a different series of returns and it leads to a different upside-downside risk capture,” Emmett said. The goal is to perform “as well or a little better” in good markets and “noticeably better” during down markets.
Blending multiple factors could be a strategy ripe for new innovations if the success of the DoubleLine Shiller Enhanced CAPE fund is any indicator. Though less than three years old, this mutual fund has combined value with a twist on momentum, actually negative momentum, and earned a spot in the top 1% of Morningstar’s large-cap value universe in 2014 and 2015.
The fund’s methodology ranks the old 10 S&P 500 industrial sectors by various metrics from one to 10 and then invests in six through nine, reasoning that the bottom sector could well be a value trap. The methodology prompted the fund to dump energy in the fall of 2014.
Jeffrey Sherman, who manages the DoubleLine fund, noted at the roundtable discussion that value had underperformed growth for nearly four years. But don’t project the past too far into the future, because valuation doesn’t always tell investors when mean reversion is coming. It does, he said, provide some indication of the likelihood of future performance.
“Growth can become cheap in certain [market conditions],” said Sherman during the discussion. “In later [stages] of a credit cycle, you want to avoid high-flyers. People tend to fall in love with certain stocks and sectors.”
One trend advisors can expect to see in the future is more blended or paired smart beta strategies. Quality, or profitability, irrespective of price can be dangerous, but when paired with valuation it becomes more attractive, several panelists noted.
Without six years of unprecedented low interest rates, serious investors would undoubtedly be worried about some other market distortion. Fifteen years ago the distortion problem was the expectation of absurdly unrealistic returns; today it is the result of older investors’ legitimate need for income.
Evan Simonoff is Editor-In-Chief of Financial Advisor magazine.