In the second part of an interview with Tim Edwards (pictured), the senior director of index investment strategy at S&P DJI Dow Jones Indices (S&P DJI) tells SRP about crowding issues around smart beta strategies, suitability, volatility and what comes next in the index market.
Why has crowding been identified as something that could negatively affect smart beta strategies?
With assets in factor indices still remaining quite small in comparison to general passive investments, it’s an academic point at present. But generally speaking, if a strategy is making a lot of money then more people will be attracted to use it, and that in itself could diminish the returns. For instance, how much can the market allocate to low volatility strategies before the returns become disappointing? That’s a hard question. But we aim to give our users a clear idea of what to expect from our indices, so it is important for us to ask it. It’s a new kind of problem: everyone can follow the market capitalisation-weighted benchmark without changing the return profile; in fact that’s one of the older arguments for passive investing generally. None the less, it’s worth emphasising that we haven’t seen evidence yet that should be a significant concern for our indices.
Are there any issues around suitability following Esma’s move to introduce tighter rules around benchmarking?
Potential conflicts of interest have to be addressed, and we applaud the European Commission (EC) in seeking to do just that. It is important that regulators, and the market overall, clearly understand how indices are used and built as well as the different models offered by the various index providers. In the long-term, recognising the differences in how indices are maintained and where conflicts may exist will be beneficial to the market.
How can index providers address issues around the volatility in assets/indices used in structured products?
The traditional structured product is a capital-protected note with a participation in the performance of a more risky asset, frequently an equity index. Underneath the hood, you can view a protected note as the combination of a bond providing the money back at maturity (capital protection) and the purchase of an option providing exposure to the asset. How much money you have left to spend on an option once you have bought the bond depends of course on interest rate environment.
Right now, interest rates are very low which means there is not much money left to buy an option, and the thing that most affects the price of the option is the volatility of the underlying asset. One solution is to tweak the underlying exposure to make it less volatile, or to have more predictable volatility. These changes in performance and risk are typically achieved either by a risk control mechanism that allocates to cash in more turbulent times, or by using low volatility techniques to pick a subset of stocks or bonds in the relevant market that are expected to be less volatile themselves. The lower (or more stable) volatility of these indices can result in better pricing of structured products for the investor and a more manageable risk profile for the issuer, the distributor and the end client.
What opportunities are you looking for in the market?
Up until a few years ago, if you knew what a benchmark index was doing, you could conclude a lot about the rest of the world. The moves in prices across multiple markets were driven by a single story - the actions of the US Federal Reserve for example. Although the story that was the most important did change from time to time, with guest appearances from ‘Grexit’ and Japanese quantitative easing, the fact remained that on any given day, only one story mattered to markets.
The most interesting thing that has happened going into 2015 is that we now have several stories being translated simultaneously into competing investment trends. We have seen currency volatility rising to levels not seen for a while, and equity volatility not reacting. Before it was one story that drove the markets now we are talking about different stories (China’s growth, Brazilian elections, Russia, Energy) as well as the old ones.
This more differentiated environment represents a challenge, but also an opportunity. Diversification becomes more valuable, for example, and at the same time there is greater opportunity to earn excess returns from a particular insight regarding a specific country, sector or stock.
What would you say is the next trend in indexing? What’s your view on multi-factor indices?
We see two big trends in structured products: income generation and risk control. I don’t think any index provider will be able to come up with a particular combination that becomes the mainstream benchmark. People are always going to have a unique preference for income versus growth, risk versus reward, exposure to global versus markets and so on. What’s a good benchmark for one will not be the right benchmark for another. Even two otherwise similar institutions may have very different preferences on technical issues like risk (are they minimising volatility, value at risk, or the risk of major drawdowns), not to mention issues driven by concerns such as socially responsible investing – which can mean very different things to different people. Nor is there an obvious way to do it. If you naively mix growth and value strategies, you get neither, at a slightly higher price of execution than the equal weight or market portfolio that results.
However, just because there is unlikely to be a single, universal multi-asset benchmark does not mean that designing them won’t become a major trend. We’ve seen an increase in requests for custom-built, multi-asset indices designed according to the end-investors individual preferences, for example. There is a lot of talk about combination of factors and even a few rotation strategies, but I think we are still at an early stage of development of smart beta, and, in the short term, it will be more important to understand how the individual factors work before we move to a different discussion.
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