Equity100, Syfe’s all-equity portfolio, is a smart beta portfolio built using a multi-factor methodology. In recent years, smart beta investing has become increasingly popular.
It is a strategy that seeks to deliver better returns by providing exposure to equity markets and to one or more factors at a lower cost. Factors are the characteristics that drive investment returns. This is why smart beta is sometimes also known as factor investing.
From an academic perspective, smart beta aims to enhance systematic returns by extracting risk premia from several factors. Risk premium is the additional return an investor receives for taking on extra risk, compared to that of a risk-free asset, in a given investment. To harvest risk premia, smart beta portfolios are tilted to one or multiple factors that contribute to outperformance.
Factors are not new. They are grounded in rigorous academic research and backed by Nobel prize-winning work, the most famous being the Fama-French three-factor model. Conceptualized by Nobel laureate Eugene Fama and Kenneth French in 1992, the model states that market returns can be explained by three factors – size, value, and market risk.
Fama and French found that, over time, small-cap stocks earned higher returns than stocks with a large market cap on a systematic basis. The value factor was established based on the stronger performance of stocks with a low price to book ratio (i.e. value stocks) as compared to stocks with a high price to book ratio (i.e. growth stocks).
Since then, other factors have been identified and become widely accepted within academia. Fama and French even expanded their three-factor model to include two additional factors in 2014.
Syfe’s multi-factor approach
One way funds use factors to construct portfolios is to select individual factors they believe will outperform and then tilt their portfolios to those factors. For instance, if fund managers wish to follow the Fama-French three-factor model, they may allocate a judicious percentage of their portfolio to small-cap and value stocks.
Similarly, Syfe’s investment team has identified three factors that will generate better risk-adjusted returns for the Equity100 portfolio: growth, large-cap, and low-volatility. These factors differ from Fama-French’s model, and with good reason.
- Growth. Since 2010, growth stocks have handily outperformed value stocks. Over the past years, much of that outperformance has been driven by technology stocks the likes of Facebook, Amazon, Apple, Netflix and Alphabet (FAANG). This is further reflected by the 260% gain made by the Russell 1000 Growth index from 2010 to 2019. Comparatively, the Russell 1000 Value index only rose 139%.
- Large-cap. For many years, small and mid-cap stocks have underperformed relative to their larger counterparts. During the March market sell-off, the disparity widened as small-cap stocks suffered much steeper losses than large-caps. This was perhaps because smaller companies have been much harder hit by the COVID-19 crisis and associated lockdowns than their larger peers.
- Low-volatility. Contrary to what many people think about “high risk, high return”, numerous studies have found that lower-volatility stocks have historically generated better risk-adjusted returns over time. Stocks, or portfolio of stocks, with low volatility tend to avoid extreme swings in price. While prices can swing upwards for a volatile stock, it can also plunge. Over the long term, it may be harder for a high volatility stock to make back what it has lost.
Reversion to the mean
Mean reversion is one of the most reliable predictors of long-term returns. In essence, it assumes that stock prices or factors move to an equilibrium level over time. When stock prices rise too high by historical standards, they will eventually correct and revert to past norms. Stock returns do not mean revert from month to month. Instead, it can take years or even decades for values to revert.
Mean reversion offers an explanation for why small-cap and value factors have not performed well over the past years. Over the decades, these factors have had to-and-fro reversions; in the current period, large-cap and growth factors are having a home run.
Dynamic factor selection
Given the current market cycle, we do not foresee the large-cap, growth and low-volatility factors to mean revert in the near future. Over the longer term however, we recognize that a factor that may be compelling during a certain market cycle may be less so in another.
Syfe has addressed this limitation by implementing a dynamic factor selection and weighting methodology for the Equity100 portfolio. Based on broader cyclical trends and changing market conditions, we will dynamically manage the factors our customers are exposed to.
For example, if large-cap stocks go out of favour over time, we might reduce the exposure to this factor by using equal-weighted ETFs instead. That’s because equal weighting greatly increases the footprint of smaller stocks.
To be sure, dynamic factor selection does not mean we will be rushing in and out of factors. In a multi-factor portfolio like Equity100, it means that we might choose to over- and underweight selected factors to generate the most optimal risk-adjusted returns based on cyclical market conditions.
How we built the Equity100 portfolio
Equity100 is not purely a smart beta portfolio. Instead, it is an optimal combination of the Global Market Portfolio with a multi-factor methodology to maximise portfolio efficiency and deliver the best possible risk-adjusted returns.
To provide exposure to a broad range of global markets, Equity100 includes the following ETFs:
- Invesco QQQ ETF (QQQ)
- iShares Core S&P 500 UCITS ETF (CSPX)
- iShares Core S&P Mid Cap ETF (IJH)
- iShares S&P 600 Small Cap ETF (IJR)
- iShares MSCI EAFE ETF (EFA)
- iShares Core MSCI Emerging Markets ETF (IEMG)
Collectively, these ETFs allow you to invest in over 1,500 companies in the US, developed market countries in Europe, Australia and Asia, and emerging market countries such as China, India and South Korea.
Our ETF selection criteria
To implement our smart beta strategy, we use the most liquid and low cost ETFs to represent our selected factor tilts. Rather than including individual stocks in the portfolio, we use ETFs to provide broad and cost-effective diversification. And by choosing liquid and low-cost ETFs, we lower our customers’ investing costs, minimise bid-ask spreads, and allow customers the flexibility to enter and exit their investments whenever they need to.
To give Equity100 a growth and large-cap tilt, we use the Invesco QQQ ETF. QQQ is a widely traded ETF that tracks the Nasdaq 100 Index and is weighted towards large-cap tech stocks that tend to be fast-growing.
The low-volatility tilt is achieved by using multiple sector ETFs – Consumer Staples, Healthcare, Utilities, and Materials. These sectors have been chosen because they collectively generate the highest risk-adjusted returns for the lowest amount of volatility on a portfolio basis. Learn more about the ETFs within the Equity100 portfolio here.
Can investors DIY?
Some investors may be wondering if it is possible to implement a smart beta strategy in a Do-It-Yourself (DIY) manner. That’s possible, of course, by using factor ETFs to provide exposure to certain desired factors.
But what distinguishes Equity100 from factor ETFs is our blend of dynamic factor selection and portfolio optimization. With Equity100, you have a 100% equity portfolio that is well diversified across global markets. You also have a portfolio that is tilted to key factors that have driven and will continue to drive outperformance.
Because factors do demonstrate some cyclicality, Syfe’s dynamic factor selection means there is no need to worry about missing out on strategic factor exposures. There is no need to analyse and choose factors as well – the Equity100 portfolio is optimised to tilt towards factors that will offer the highest potential risk-adjusted returns in the long run.
Smart beta made better with Equity100
Apart from the convenience and peace-of-mind that comes with a ready-made and professionally managed smart beta portfolio, there’s also the cost advantage Equity100 has.
The portfolio holds multiple ETFs. Replicating these ETFs would cost the DIY investor significantly in terms of brokerage fees and minimum investments. A better option would be to enjoy $0 brokerage fees and no investment minimums with Equity100. This way, investors can enjoy the long-term better risk-adjusted returns of smart beta factors while keeping their costs low.