Engineered Beta

The extraordinarily challenging investment environment of recent years has caused many investors to question traditional methodologies and seek alternative investment strategies. Although the “core-satellite” approach remains widely used, the recent market dislocations have given rise to a need and opportunity to re-engineer the allocations.

A core-satellite strategy consists of a focus on core exposures to relatively efficient market segments, increasingly implemented using index strategies, that is augmented by satellite allocations intended to provide exposures to more specialized areas in search of improved overall returns. Using index strategies for the core can offer investors several benefits, including a uniform and consistent exposure to a market portfolio, transparent methodologies and relatively low costs. A primary goal of the core is to replicate as closely as possible the risk and return characteristics of the market segment represented by the selected index, referred to generally as “market beta.”

Engineered beta portfolios seek to balance the achievement of a specific, actively targeted exposure with the client’s diversification and volatility goals.

Historically, active management has been used to fill out the satellite roles in an effort to gain enhanced returns, or alpha, through the specialized expertise offered by individual investment managers. This approach has been increasingly challenged, however, as a result of inconsistent returns, relatively high cost — either explicitly in management fees or implicitly in higher transaction costs resulting from high turnover — and, in some cases, a lack of transparency. A new approach, referred to as “engineered beta,” may allow investors to obtain the specialized exposures sometimes associated with active management while keeping many of the transparency, consistency and execution cost advantages inherent in passive approaches.

Engineered beta portfolios seek to balance the achievement of a specific, actively targeted exposure with the client’s diversification and volatility goals. They are frequently custom-designed to suit an investor’s specific needs in a disciplined and targeted fashion, and, depending on those needs, may play either the core or satellite roles.

“Engineered beta is simply the isolation of certain factors, whether sectors, industries, or regions, or more risk-specific factors, like value or growth, or some quality-type of measure,” explains Joseph E. Wolfe, CFA, CQF, FRM, quantitative equity portfolio manager and researcher at Northern Trust, Chicago.

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The Evolution of Engineered Beta

Much has been written on the relationship between risk and stock returns in financial journals during the past 50 years. The Capital Asset Pricing Model (CAPM) provided a framework for understanding portfolio risk, but assumed that the sensitivity to the market portfolio was the only beta that mattered. Almost immediately after the CAPM’s development between 1964 and 1966, alternative models were proposed by financial economists.

One popular alternative was the Arbitrage Pricing Theory (APT) model developed by Stephen Ross in 1976. The theory differs from CAPM in stating that there are linear and measurable relationships between expected returns and multiple factors, not just the single market beta. While many will agree that the market portfolio will be the dominant factor over a complete market cycle, other factors can dominate over shorter intervals as evidenced by bubbles throughout recent history.

The theoretical structure of the APT naturally lends itself to engineered beta-type strategies. For example, investors may have a need for regular income but still wish to use a conventional index as a primary indicator in their risk management process. This requirement can be satisfied by a portfolio biased toward a “yield beta,” but with overall portfolio risk constrained in relation to the index designated by the client.

“Think of it like an ice cube tray with all the buckets equally filled. Engineered strategies tilt the tray so the water flows toward the targeted betas, like size and value,” Wolfe says.

Specific investor needs can be met using more targeted approaches to factor exposure, while retaining many of the benefits of passive management.

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Different Skill Sets Required

Given that engineered beta is frequently implemented as a customized approach that aims to harvest the best features of index management and active management, successfully designing an engineered beta strategy requires a combination of quantitative skill and indexing skill.

“Quantitative expertise is required to accurately and confidently define the desired exposure in consultation with the investor and determine how to best achieve that in an actual portfolio,” says Scott R. Ayres, senior product manager at Northern Trust, Chicago. “Essentially, the quantitative aspect should not only address the investor’s desired exposure, but, of equal importance, the control of risk exposures to other factors the investor seeks to avoid.”

Ayres adds that indexing expertise is beneficial in providing the ability to implement custom-designed portfolios efficiently and in a way that will represent the desired beta accurately while also minimizing tracking error that can quickly lead to excessive volatility in the portfolio. Potential sources of volatility include, but are not limited to, liquidity concerns, rebalancing strategies and managing around various corporate actions that have an impact on the stocks in the index.

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Putting Theory into Practice

To better understand how engineered beta works, consider the example of an insurance company that turned to engineered beta as an alternative method of generating income from its investment portfolio.

The company had been using municipal fixed-income securities to generate income but was concerned about low interest rates, issuer quality, market liquidity and the possibility of increased inflation. The insurer approached Northern Trust to discuss the possibility of implementing a dividend-based equity strategy, which offered an attractive after-tax yield and the possibility of better inflation protection, but several undesirable aspects as well.

“After consulting with the company, we conducted research that indicated that most of the strategies currently available were subject to several drawbacks, including highly concentrated positions, high relative volatility and the inclusion of lower-quality companies that might not be able to sustain their dividend payments,” notes Mark C. Sodergren, CFA, senior portfolio manager at Northern Trust, Chicago.

Instead, Northern Trust developed a dividend-based equity strategy that provided increased dividend income in a risk-controlled manner while screening out low-quality companies that were less likely to maintain their dividend payments. The initial proposed portfolio was not linked to any index, but rather was driven purely by the factor optimization process, providing a pure exposure to the risk factors suggested. The client, however, wanted to retain the ability to incorporate the portfolio easily into their global risk budget, and so the portfolio was re-optimized using their desired benchmark for domestic equity, the Russell 3000 Index.

The portfolio was designed to achieve the client’s dividend yield target of 3.5% while maintaining risk characteristics similar to the client’s investment policy benchmark. Furthermore, the strategy’s focus on dividend sustainability provided an opportunity for dividend increases over time, which could act as a potential hedge against future inflation. The resulting portfolio provided sufficient cash flow to meet the company’s requirements and it was designed to be managed in a tax-conscious manner. In the end, it was selected to form the core exposure.

“The same capabilities used to construct this response to a specific investor need can be used in structuring a number of different solutions to various problems,” notes Matt Peron, global head of active equity management at Northern Trust, Chicago.

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Beyond Traditional Indexing

Conventional indexing provides significant advantages in the form of consistency of results, reduced cost and transparency of process. In many cases, a carefully constructed exposure to the market beta using one or more conventional third-party indices is well suited to achieving an investor’s overall objectives. In addition, index providers are constantly researching new approaches to building these indices, offering alternative approaches.

There are other cases, however, where specific investor needs can be met using more targeted approaches to factor exposure, while retaining many of the benefits of passive management. These exposures can be “engineered” along many lines, and in some cases the best result might come from a combination of factor exposures not readily available in a conventional third-party index.

Such engineering requires a consultative approach combined with specific analytical skills to assure achieving the desired exposure while limiting unintended risk exposures, as well as the specialized skill sets inherent in passive portfolio management. The resulting “engineered beta” solution may provide a highly favorable result to the investor.

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