By Thomas Reif

Global stock markets seem to be on a roll, with volatility unusually low despite tensions over North Korea and political infighting in the United States. But rallies ultimately end, so what can international equity investors do now to ensure they keep on track with their investment goals? In our previous article, we explained the concepts of smart beta and factors. In this second instalment of our series, we focus on how blending multiple factors can help investors navigate changing market conditions.

When markets are climbing, investor complacency tends to go high as well. But smart investors should also be thinking about what to do when the good times end. Ideally, investors would want to see their portfolios benefit from the rally for as long as possible, yet be protected from any reversal.

The conventional way of protecting against downside risk is to shift to a more conservative, fixed-income-based portfolio. However, given the prevailing low return expectations, a more conservative portfolio may not earn enough to meet investors’ goals and timing the market can be tricky.

What if we say there’s an equity portfolio that can provide consistent exposure to both growth and defensive factors aimed at providing smoother returns as market conditions change? Using smart beta, an investment strategy that harnesses the drivers of equity risk and return or “factors”, investors can have a portfolio that’s more responsive to market cycles.
 
Smoother returns

The outperformance of factors over broad market-cap indices has been well-researched for decades. In our previous article, we introduced some of the commonly accepted factors; here is a recap of their general characteristics.

  • Value: Value stocks trade at a low price relative to their fundamentals, such as earnings or sales.
  • Low volatility: Volatility measures the distribution of returns and is considered an effective way of gauging future expected risk.
  • Quality: This factor focuses on companies with low debt, stable earnings and high profitability.

 
With these attributes, it’s no surprise that factors perform differently in different market conditions. Quality and low volatility strategies tend to outperform in market downturns, while value strategies usually deliver their strongest returns in risk-seeking environments.
 
A strategy that combines these factors in a single portfolio — or a multi-factor smart beta strategy — offers diversification throughout the business cycle, with at least one factor working in favour with the business cycle when others drag. The potential result is a more consistent and smoother return stream over the long run.
 
Multi-factor smart beta in action
 
So how does the strategy work in practice? Let’s consider the SPDR® MSCI World Quality Mix Fund (QMIX), an exchange traded fund (ETF) traded on the ASX that provides exposure to over 500 large to midcap stocks in more than 20 developed nations, including Australia. The Fund seeks to track the performance of the MSCI World Factor Mix A-Series Index which aims to represent the combined risk/return performance characteristics of quality, value and low volatility factors within global developed equities. Combining these three factor indexes in equal proportions has historically offered a smoother performance ride and greater diversification compared to individual factor indexes.

In Figure 1, we've compared the performance of the QMIX ETF and its underlying Factors against the MSCI World Index (as representative of a broad market cap index).

In the volatile days following the surprise Brexit vote on 23 June 2016, investors may have found it difficult to sell their stock holdings and shift to more defensive stocks without the risk of losing money. But an investor with a multi-factor smart beta portfolio could have already been defensively positioned without having to make a single transaction.

In this case, QMIX managed to cushion volatility during this period and ride the upside when markets recovered. QMIX’s three factors performed differently – value stocks underperformed, but high quality and low volatility stocks outperformed, compensating for value.

Figure 1. QMIX and Single Factor Index cumulative excess performance returns versus MSCI World Index

Source: SSGA, as at 22 August 2016.
Past performance is not a reliable guide to future performance
Returns are measured in AUD and reflect the cumulative excess performance return for MSCI World Index vs MSCI World Value Weighted Index ("Value"), MSCI World Index vs MSCI World Quality Index ("Quality"), MSCI World Index vs SPDR MSCI World Quality Mix Fund ("QMIX"), and MSCI World ex Australia Index vs MSCI World ex Australia Minimum Volatility Index (AUD) (Minimum Volatility). The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. The QMIX performance figures contained herein are provided on a net of fees basis, before taxes but after management and transaction costs. Returns have been calculated assuming reinvestment of all distributions and is calculated in AUD. Returns do not reflect the brokerage fees or the bid/ask spread that investors pay to buy and sell ETF securities on the Australian Securities Exchange.

Why smart beta?
Active managers have long harnessed the power of factors to beat their benchmarks over time. The difference with smart beta is that it seeks to harness this power of factors by using a systematic, low-cost and transparent approach more synonymous with passive investing.

Investors can use an index that’s specifically designed to screen for the desired factors. This rules-based approach can potentially result in consistent positive exposure to the desired factors over time as well as cost reduction. And in today’s low-return environment, lower fees mean you get to keep more of your returns.

A growing number of multi-factor smart beta ETFs globally has made it easier for investors to access this opportunity.  So instead of divining winners and market trends, why not consider a multi-factor smart beta strategy to diversify your exposure for different market conditions?

Learn more about QMIX and multi-factor smart beta investing at spdrs.com.au.

This is a sponsored article from State Street Global Advisors.

Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900, ABN 16 108 671 441) ("SSGA, ASL") www.spdrs.com.au. This material is of a general nature only and does not constitute personal advice. It does not constitute investment advice and it should not be relied on as such. It does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. You should seek professional advice and consider a products disclosure statement, before making an investment decision. ©2017 State Street Corporation —All Rights Reserved. AUSMKT-3899 | Expiry date: 30 September 2018.