Beating volatility with advanced beta strategies

The value of assets under management (AUM) across the world reached $56.4 trillion in 2010, surpassing the previous historical high of $56.2 trillion in 2007, according to Boston Consulting Group. Global AUM growth in 2010 was driven largely by the fact that equity markets continued to recover in 2009 and 2010, after they crashed following the subprime-sparked financial crisis in 2008.

Emerging market equity funds have become a top priority for asset managers in the US and Europe, thanks to the greater opportunities and higher returns these markets offer. And those decisions have paid off, with the increased focus on emerging market equities helping asset managers to improve revenue margins in 2010, according to the BCG report.

But volatility is also making retail investors wary of equity funds. To address the volatility, State Street Global Advisors suggests advanced beta – a non-market capitalisation benchmark strategy – as a consistent, transparent and accurate method of gauging asset allocation priorities for debt and equities.

“Index funds typically are cap-weighted,” said Eric Brandhorst, director of research for global equity beta solutions at State Street Global Advisors, at a briefing this week. But Brandhorst suggests that cap-weighted strategies might not be as effective in a bubble environment, such as Japan’s equity market during the 1980s, the dotcom exuberance a decade ago and the volatile market recently. As a case in point, a portfolio constructed by investing “equally” in the stocks that comprise the MSCI world index would have outperformed the cap-weighted MSCI world index fund by 61% during the past 10 years, said Brandhorst.

Advanced beta delivers better returns over time, said Brandhorst. “The FTSE RAFI (fundamental indexing) All-world 3000 has outperformed its counterpart FTSE All-World by 69% over the past 10 years.” Non-market cap benchmark strategies are weighted according to particular attributes such as value, size and credit scores. “A fundamental-weighted index takes the same stocks but allocates capital to the stocks in proportion to some underlying measurable fundamentals like earnings, good balance sheets or sales,” Brandhorst explained.

Minimum volatility strategies, which use an advanced beta approach to build a portfolio of low-volatility stocks, performed well earlier this year when US debt was downgraded by S&P and the EU sovereign crisis worsened.

Advanced beta works for long-term investors, but might not be ideal for short-term investments, added Ken Wong, equities product engineer at SSgA.

Advanced beta is also applicable to fixed income markets. Traditional cap-weight strategies carry an inherent structural bias to countries that borrow more, and therefore can lead to increased allocation to relatively over-valued markets even if yields in those countries fall. To address this problem, Lochiel Crafter, the senior managing director and head of investments for Asia at SSgA, suggests an issuer-scored corporate index (ISCI) strategy, which weights bonds in a portfolio in proportion to fundamentals such as profitability and efficiency, and captures the true drivers of risk/return in bonds. Historical data has shown that ISCI maintains higher risk-adjusted returns in both low- and high-volatility environments.

The volatility of the market has continued to challenge asset managers’ abilities to manage their portfolio and drive financial innovation. “Instead of predicting the future of companies, we could look back at the historical record to determine asset allocation strategies,” Wong added.