MSCI: Factors can help achieve a target risk return profile
Following the launch of the MSCI series of Diversified Multi-Factor Indexes that track the performance of four factors including value, momentum, quality and low size, SRP spoke to Altaf Kassam (pictured), managing director and head of equity applied research, Europe, Middle East, Africa and India at the index provider, about the increasing demand for smart beta strategies in passive investments, the role of active asset managers, and how factor investing can be replicated via indices and deployed through structured products.
Is passive investing taking over active management?
At MSCI, there is a role for both passive and active asset management alongside factor investing. These are not exclusive and should exist together. You should decide if you only want exposure to equities, or if you have a view on a particular factor, tilt, geography or sector. Going pure market cap passive via MSCI World would be the best approach to get passive exposure to the equity risk premium as [this approach] is cheap, transparent, and has a low turnover. If you want to go beyond that, and you believe that factors can provide you with the more targeted exposure to equities you want, then you can use one of the indexes within MSCI’s Factor Index range. But if you want to get alpha which is beyond what you can get with indexes and which can only be achieved through stock selection, market timing, pure discretion…then you should go via active asset management. Each level will have extra costs and the turnover will also increase. Investors need to be aware of this to make informed decisions.
Are smart beta strategies threatening active asset management?
We saw what happened with exchange-traded funds (ETFs) in the early 1990s. At the time, product providers were able to take something that was previously available only through actively-managed funds and turn it into something that is now available through low cost systematic transparent instruments. This is now happening again with factor investing. I don’t think it is a failure of the asset management industry, but a reflection that investors are now holding active managers to a higher standard. Investors have realised that they should expect more from active managers. In the past, only the market beta component of active management could be achieved via an ETF, but what was considered alpha then can now be split into factor investing and pure alpha. Investors now expect active managers to deliver only pure alpha for the fees they charge. If investors see that active managers are relying on exposure to factors, they can now think about replacing them with indexes that capture these factors.
Are factor indexes providing access to strategies that were exclusive to active managers in the past?
Structured products are a very interesting way to make these [factor investing] strategies available to the wider investment public. It is important, however, that investors understand the risks of factor investing. These indexes can fit into structured products because factor indexes can help achieve a target risk return profile that structured products are designed to deliver. To make embedded call options cheaper, providers might want high dividends and low volatility from the underlying index, and this can be achieved through a combination of factor indexes. At MSCI, our factor index range is very well suited for structured products, but investors need to understand what is embedded in these indexes and how liquid they are, because the dealer of a structured product has to hedge those elements, and these are important considerations in terms of the cost and liquidity of the final product.
Why are ETFs driving most of the activity around smart beta investing, as opposed to structured products?
So far the dominant commercial model for structured products has been pretty much a retail product sold locally on a country basis, and a lot of the markets that have single country indexes have less exposure to smart beta/factor indexes. ETFs seem to be more used on a global basis, ie. US investors looking for access/exposure outside the US, or investors looking to access emerging markets. That is why smart beta has not really taken off in the structured products market but is fast gaining share in the ETF market. One thing that smart beta indexes need is breadth, given that a large number of stocks are required in order to make them work properly – something you wouldn’t get with many local market indexes, which have a limited number of stocks.
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