Indexology^® Blog

It is now a well-established trend that institutional investors are allocating to smart beta / risk premia strategies. In a recent survey of 300 institutional investors, 42% of the investors say they have committed a portion of their portfolios to smart beta, while a further 24% say they intend to do so in the future. Regionally speaking, Europe has led the way in the adoption of smart beta, as there are a much higher percentage of European institutional investors making allocation than that of North America and Asia Pacific.

Smart beta strategies typically capture some of the well-known systematic risk premia, such as small cap, value, low volatility, momentum and quality in equities, as well as curve, value, and momentum in commodities. Investors are increasingly using such strategies as building blocks of asset allocation, often with an objective to achieve certain investment outcomes, such as volatility reduction, diversification, and return enhancement.

Exhibit: Categorization of Smart Beta Equity Strategies

Source:  S&P Dow Jones Indices.

The development of smart beta strategies represents an opportunity for individual and institutional investors, as it expands the toolkits investors can use in their portfolio construction and asset allocation. As investors become increasingly aware of the potential benefits and risks of smart beta strategies, the adoption of smart beta may continue to gather pace over the coming years. In particular, investors may increasingly take a multi-factor and multi-asset-class approach to smart beta investing, where they aim to harvest risk premia across asset classes via efficient and low cost vehicles.

Join us at our complimentary seminars to hear our panel of industry thinkers discuss the trends, opportunities and challenges in incorporating smart beta and risk premia strategies in asset allocation. Register here: http://bit.ly/1jDrPqj

2013 was a seminal year for US equities with markets going up 33%. Emerging markets on the other hand did not fare so well and were relatively flat with a negative 1.27%. India ended the year down at 4.8%, hit strongly by currency woes, but the year was very volatile for most emerging markets. Some countries, famously dubbed as the ‘Fragile Five’ , namely Brazil, India, South Africa, Indonesia and Turkey are seen as more vulnerable than others, largely because of slowing economic growth, high inflation, large fiscal deficits, and depreciating currencies. These countries have come to symbolize what seems to ail emerging markets in general, which have depended on large foreign investments to fund their economic growth and fill their current account deficits. Some have even likened the situation to the Asian crisis of 1997, but a number of factors including the emerging markets own higher sophistication and awareness of such perils discounts such a possibility.

The US Federal Reserve’s announcement last summer of tapering the Quantitative easing sent shivers down the emerging markets spine. When liquidity dries up in the largest market in the world, albeit slowly and surely, the first to be hit are the riskier investments and emerging markets will be the first to feel that impact. The US economy is working under a cautious note of optimism that economic growth is back on track post 2008, and tapering will not really hurt growth prospects. Indeed the decision on tapering is itself seen as a vote of confidence that the economic growth is on track in the 2-3% range. Emerging markets are feeling the impact of the announced tapering more. The Indian government has put curbing inflation high on its agenda ahead of economic growth as can be seen by a number of rate increases in the previous months. Plans are being laid out to limit fiscal deficit to 4.6% of GDP as per the interim budget and the Indian Rupee has remained somewhat stable in the RS 62-63 range.

Overall, the short term volatility seen in emerging markets need not become a long term trend, but is more a result of uncertain economic and political situation in some of the emerging markets including India, but if the measures to limit the deficits and boost investment and growth are successful we can expect to see more stable market trends in the coming months. Over the long term investors remain committed to India, but over the short term a few see this as a buying opportunity while the majority prefer a wait and watch policy with expectations that the bottom may be finally close.

Watch the live interview with ET Now.

The weekend meeting of 20 major global economies representing 85% of world GDP called for adding half a percentage point of growth each year to 2018 through renewed and aggressive stimulus.  So far this is talk, but there is a chance for action.  The G20 will convene again in November to show what they’ve done.  Policy shifts and the move to stimulus will be focused on the developed countries – emerging markets will focus on debt and currency issues. Stimulus programs will differ from one country to another. Europe is likely to see renewed calls for more easing from the ECB and more open labor markets.

US picture is different: The Fed is firmly on course to taper QE3 and gradually move to tighter monetary policy, especially after the FOMC mentioned raising interest rates.  As a result the focus will shift to fiscal policy.  This fits with the Administration’s goals to talk about taxes and income distribution and to increase spending in anticipation of the fall mid-term Congressional elections.  With the debt ceiling set aside until March 2015, there is a chance for a fiscal policy discussion that isn’t driven by fears of the deficit.

Stimulus — both domestic and international – should be a plus for the stock market, but probably not a big enough plus to give us a repeat of 2013’s market results.  For fixed income, stimulus and tighter Fed policy mean higher interest rates.

Your portfolio is like a hockey team.  You don’t think so?  It is.  And VIX plays a key role.  Stay with me while I explain.

Equities are your guys playing at center and on the wings.  You expect production from them.  Your team largely lives and dies by how consistently they score.  Bonds are your defensemen.  They come forward to create some additional offense at times, but their key responsibility is minimizing downside risk.  The goalie?  Perhaps not a perfect analogy, but let’s liken him to cash.  Your last line of defense.

Where does the CBOE Volatility Index (VIX) fit in all this?  Yes, if VIX were a hockey player, it would likely be on defense.  But VIX is a special type of defensive player.  In hockey parlance, VIX is an enforcer.

Someone took the time to write up a great description of what a hockey enforcer is.  “An enforcer’s job is to deter and respond to dirty or violent play. . .the enforcer is expected to respond aggressively. . .”  Further, “Enforcers are typically among the lowest scoring players on the team and receive a smaller share of ice time.”  In other words, most of the time you can’t expect much from an enforcer and you may not want to have him on the ice much.  But when it’s time for the enforcer to come to the rescue and protect the team, he does it in a big way — aggressively.

In your portfolio, VIX is your enforcer.  Maintaining a VIX position can be painful.  You would want to be selective as to when to allocate to VIX. But when things get really rough, you want to have VIX in the mix so it can aggressively defend your portfolio’s value, when every other asset class slinks away.

Below is a chart showing the performance of major indices during the last half of 2008, when the equivalent of a major hockey brawl broke out.  You remember it – broken teeth and blood on the ice everywhere.  VIX came to the rescue.  Those who allocated even a small portion of their portfolio to VIX linked instruments got some serious protection.

The 2008 crisis wasn’t the only time VIX stepped up.  Time after time, VIX and the instruments linked to them have responded quickly and in a pronounced way to violent market moves.

We are still in turbulent times.  If you feel under threat, you may want to hire an enforcer.

Join us for a live teleconference on the US housing market on February 25th @ 10am EST. Featured speakers to include Professor Robert Shiller, Professor of Economics at Yale University and David Blitzer, Managing Director and Chairman of the Index Committee at S&P Dow Jones Indices. Instructions to access the teleconference are as follows:

Net Enhanced and Audio Streaming Info:

https://www.mymeetings.com/nc/join.php?i=PG4463870&p=INDICES&t=c

Or follow manual steps below:

URL: https://www.mymeetings.com/nc/join/
Conference number: PG4463870; Audience passcode: INDICES

Audio Streaming: (Audio Only)

http://event.on24.com/r.htm?e=754248&s=1&k=F4FA5732F644E1C30EAE3504F39A8375