Objectives matter in active investing – that's why focusing on investment outcomes can add insight and focus to an investors' aims.
The best-known forms of active investing are often based on categories – for example, by market-cap –Large Cap or Small Cap; or by "style" – Growth or Value. And most active investment managers have their performance measured in terms of their investment returns within category benchmarks. They're also compared within "peer groups" of investors with similar objectives.
One key challenge for the asset management business is the mismatch between standard investment-objective groupings and the investment outcomes sought by a wide array of investors – such as capital preservation, reduced volatility, and income generation. This mismatch has encouraged the creation of new types of investments, including alternative asset classes, absolute return strategies, and several varieties of so-called "smart beta".
The facts on factor-based investing
Most current smart beta ETF offerings are “factor-based” — with investment objectives targeting specific performance characteristics such as price momentum or volatility; valuation ratios such as price-to-earnings (P/E); or accounting ratios such as return-on-assets.
A second category of offerings can be thought of as “fundamental weighting” — either bottom-up weighting of stocks by company fundamentals such as total earnings or dividends, or top-down country allocation based on economic indicators such as Gross Domestic Product. A third category — “enhanced diversification,” has the stated objective of improving on traditional forms of asset class diversification with techniques such as risk parity, diversity weighting, or risk clustering. These three categories have one important thing in common — they’re aimed at addressing shortcomings of more conventional cap-weighted investments, and are the basis of many of the current "smart beta" offerings in today's marketplace.
But these smart beta solutions can generate widely contrasting results from each other in differing market conditions — even within seemingly similar categories. So it’s useful to find a better way to distinguish them from each other, based on principles more solid than which factors or methods they employ.
Outcome based investing: The basics
In part because of this challenge, Legg Mason investment affiliate QS Investors has conducted and published research into the matter,1 and has proposed a classification system based on investment outcomes rather than on investment process. Outcome-based categories can make it possible to bring order to smart beta, as well as to other types of investment classification – including popular systems based on investment processes.
Exhibit 1 Core, Style investing and portfolio construction methods
Matching outcome-based categories with three types of "smart beta" approaches
Source: QS Investors. Past performance is no guarantee of future results.
QS Investors’ data analysis has shown that the return profiles of the three portfolio construction techniques (Enhanced Diversification, Fundamental Weighting, and Factor Based) clustered around two outcome-based categories: Core Investing and Style Investing. Within Style, we identified Momentum, Value and Defensive Investing. Exhibit 1 summarizes the findings, showing how the three portfolio construction techniques line up with QS Investors' findings. Perhaps the most notable aspect: while Enhanced-diversification and Fundamental-weighting approaches offer return characteristics similar to style-neutral "Core" returns, most factor-based approaches – some of the most common in the "smart-beta" category – show distinct style-based "tilts" which could potentially limit their capacity to either limit downside capture, or enhance upside capture.
Investment considerations for Core and Style investing
Understanding how these categories behave in different market environments is critical to fully understanding their investment outcomes — and how they can contribute to their objectives. The behavior of these categories has been widely divergent over the past 35 years. Two notable examples: First, Style, in all three of its flavors, has tended to generate more extreme results than other approaches; Core has tended to react in a more balanced fashion.
Second, the traditional Core equity choice, capitalization- weighted indexes, suffers from concentration risk. Cap-weighted indexes accumulate their largest allocations to market bubbles exactly at their peak. One example of note: the Internet Crash of 2000–2002 pulled the cap-weighted “Style” down with it.
Conclusion: Beyond benchmarks and smart beta
Not all outcome-driven alternatives to benchmark-driven and smart-beta investing are created equal. For investors seeking to balance the constantly changing nature of market risk with the potential to participate in the returns inherent in the asset class, investors should focus on investment outcomes that support investors’ long- term objectives.
1 De Boer, Labella, Reifsteck, “A Taxonomy of Beta Based on Investment Outcomes”, Journal of Index Investing, Vol 7 Number 1, Summer 2016