PowerShares is planning to launch five factor ETFs based on the S&P 500, according to an SEC filing. It’s one more sign that a new era is dawning for alternative betas and enhanced asset allocation opportunities.
The proposed ETFs from PowerShares:
S&P 500 High Beta Portfolio
S&P 500 Low Beta Portfolio
S&P 500 High Momentum Portfolio
S&P 500 High Volatility Portfolio
S&P 500 Low Volatility Portfolio
There’s already a fairly intriguing lineup of funds targeting specific factors. A few examples include the S&P 500 VIX Short-Term Futures Index, AQR’s trio of equity momentum index funds, the PowerShares DB G10 Currency Harvest Fund, the Merger Fund, and the iPathUS Treasury Steepener and iPath US Treasury Flattener ETNs.
The latest PowerShares proposal suggests that we’ll be seeing more funds that mine previously untapped strategies/unconventional betas in the months and years ahead. Strategically speaking, an expanding menu of products targeting specific risk factors expands opportunity for asset allocation beyond the possibilities bound up with conventional betas. It’s hardly a free lunch, but for sophisticated investors who understand the risks it all adds up to a productive evolution in fund choices. Indeed, more is better when it comes to the beta menu because in theory additional funds boost the ability to generate better results and weather rough investment seas.
Securitizing new factors has, in fact, been going on for years. It’s old hat now, but once upon a time there was a new-fangled beta focus called small-cap and value equity funds, for instance. Over the years, the list has continued to lengthen, such as adding high-yield bond funds and emerging market equity funds. More recently, we’ve seen the first generation of index funds targeting foreign bonds denominated in foreign currencies. And, of course, there’s also been an explosion of forex funds proper.
Overall, it’s fair to say that fund companies have been filling out their product lines over the last decade or so in the basic corners of risk factors. As a result, there’s a broad array of index funds targeting stocks, bonds, REITs and commodities, along with numerous subsets of each. There’s also a niche arena with short and levered exposures as well. This phase of the securitizing standard betas is now nearly complete.
But the era of securitizing unconventional betas has only just begun. Why is this relevant? Because the trend of minting new funds that capture various factor exposures potentially opens the door to a wider menu of asset allocation possibilities. In theory, the ability to tap into an expanded set of betas enhances the possibility of juicing risk-adjusted return. Asset allocation benefits from additional choices, in part because investors can exploit the varying risk profiles and lower correlations between standard and alternative betas. As a 2009 research monograph published by MSCI Barra explained, an expanded palette of betas improves the strategic opportunities for raising return, lowering risk, or both.
The improved asset allocation possibilities are partly a function of lower correlations between alternative betas and their conventional counterparts. What’s more, correlations between alternative betas are often low or even negative. Consider a table from the MSCI Barra paper, which summarizes correlations between a select list of factors:
The basic message is that alternative betas exhibit lower correlations with both standard asset classes and among themselves. The data in the table above, the MSCI Barra research observes, reflect that “most of the correlations are below 0.25 and confirm that the risk premia captured unique return characteristics and offered diversification over this period. Note the highly negative correlation of -0.47 between Momentum and Value – two factors that are often deployed in quantitative equity investing.” (A correlation of 1.0 indicates perfect positive correlation; a correlation reading of zero indicates no correlation, and -1.0 reflects perfect negative correlation.)
The accompanying challenge in this brave new world of alternative betas is that much of the common wisdom that’s been developed with standard asset allocation will require an upgrade. Although academic researchers have long toiled in this arena, moving portfolio strategy to the next level for the masses is still in its infancy.
One aspect of this learning curve is understanding how alternative betas interact with one another. It’s not always as intuitive as it is with standard betas. As such, mindlessly diversifying doesn’t necessarily add value when it comes to non-standard factors. For instance, as MSCI Barra notes, “the correlation between high yield and credit spread is high at 0.56, suggesting that these two factors are at least partially redundant.”
By contrast, you can be reasonably confident that diversifying among all the standard betas is generally a productive move. If you only own stocks, for instance, you don’t need to analyze a correlation matrix to rationalize the case for owning some bonds, REITs and commodities. Or, if you only only domestic stocks, expanding the portfolio into foreign equities is a no-brainer.
On the other hand, deciding if merger arb and convertible arb, or the carry trade and currency momentum, are complimentary pairings requires deeper analysis. Greater complexity can be a friend, but it may be a foe, depending on the investor, the prevailing market and economic conditions, and the set of factors under consideration.
The details matter for the individual funds as well. Simply rolling out a new alternative beta ETF or ETN in and of itself isn’t a reason to buy the product. Expenses tend to be higher (perhaps dramatically higher) in this niche compared with the indexing of conventional betas, and so the stakes are higher for evaluating each fund on a case-by-case basis. The expected risk premium for certain alternative betas can look good on paper but end up as far less attractive (or even negative) in the real world after deducting expenses and navigating the extra layers of complication for mining these financial niches. Capturing the effects of some factors, in other words, can be costly and complicated compared with replicating standard betas.
Nonetheless, the future for asset allocation is evolving, one alternative beta product at a time. That’s generally a step in the right direction. If we think of asset allocation as a chess game, portfolio management is shifting from a conventional one-dimensional board to 3-D chess. Accordingly, we’re entering a new era of possibilities for minting superior results. But there’s also more complication and higher expenses to consider.
The core rule of investing, however, is unchanged. The opportunity for earning higher returns comes prepackaged with the possibility of suffering bigger losses. Risk and return are still closely linked in new world of betas, even if those connections are becoming more nuanced and varied.