Tag Archives: factor exposures

Property and Casualty Industry Crowding

Property and casualty insurance company portfolios share a few systematic bets. These crowded bets are the main sources of the industry’s and many individual companies’ relative investment performance. Since the end of 2013, these exposures have cost the industry billions.

Identifying Property and Casualty Industry Crowding

This analysis of property and casualty (P&C) insurance industry portfolios resulted from collaboration with Peer Analytics, the only provider of accurate peer universe comparisons to the insurance industry.

In analyzing property and casualty industry portfolios, we follow the approach of our earlier articles on crowding: We created a position-weighted portfolio (P&C Aggregate) consisting of all property and casualty insurance portfolios reported in regulatory filings. P&C Aggregate covers over 1,300 companies with total portfolio value over $300 billion. We analyzed P&C Aggregate’s risk relative to Russell 3000 index (a close proxy for the U.S. Market) using AlphaBetaWorks’ Statistical Equity Risk Model to identify sources of crowding.

Property and Casualty Industry 2014-2015 Underperformance

P&C Aggregate systematic (factor) performance lagged the market by over 4%, or over $12 billion, since the end of 2013. This is largely due to low (short, underweight) exposures to Market (Beta), Health, and Technology factors:

Chart of the factor returns of the Property and Casualty Industry’s Aggregate Portfolio relative to Market during 2014-2015

2014-2015 Underperformance due to Property and Casualty Industry’s Portfolio Factor Exposures

Below are the main contributing exposures, in percent:

Factor	Return	Portfolio Exposure	Benchmark Exposure	Relative Exposure	Portfolio Return	Benchmark Return	Relative Return
Market	16.64	91.90	99.97	-8.07	15.25	16.63	-1.39
Health	21.12	6.59	13.09	-6.50	1.30	2.58	-1.29
Technology	5.93	8.93	19.10	-10.17	0.53	1.13	-0.60
FX	21.94	-3.72	-1.19	-2.53	-0.75	-0.24	-0.51
Energy	-25.18	7.26	5.67	1.59	-1.99	-1.56	-0.43

For some companies, these exposures may be due to conscious portfolio and risk management processes. For others, they may have been unintended. For industry as a whole, robust risk and portfolio management would have generated billions in additional returns.

Property and Casualty Industry Year-end 2013 Crowding

Property and casualty industry’s recent crowding has been costly in practice. P&C Aggregate’s relative factor bets have cost it over 4% since year-end 2013. The industry made $12 billion less than it would have if it had simply matched market factor exposures.

Year-end 2013 Systematic (Factor) Exposures

Below are P&C Aggregate’s most significant factor exposures (Portfolio in red) relative to Russell 3000 (Benchmark in gray) as of 12/31/2013:

Chart of the factor exposures contributing most to the factor variance of Property and Casualty Industry’s Aggregate Portfolio relative to Market on 12/31/2013

Factors Contributing Most to the Relative Portfolio Risk for Property and Casualty Industry Aggregate on 12/31/2013

P&C Aggregate’s factor exposures drive its systematic returns in various scenarios. The exposures above (underweight Market and Technology factors) suggest the P&C industry is preparing for technology crash akin to 2001. This and other historical regimes provide the stress tests below, similar to those now required of numerous managers.

Property and Casualty Industry Year-end 2014 Crowding

Year-end 2014 Systematic (Factor) Exposures

Property and casualty industry portfolio turnover is low. Consequently, industry factor exposures at year-end 2014 were close to those at year-end 2013. Below are P&C Aggregate’s most significant factor exposures (Portfolio in red) relative to Russell 3000 (Benchmark in gray) as of 12/31/2014:

Factors Contributing Most to the Relative Portfolio Risk for Property and Casualty Industry Aggregate on 12/31/2014

The main exposures of the property and casualty industry were: short/underweight Market (Beta), long/overweight Size (large companies), short Health, and short Technology. The industry crowds towards large and low-beta Consumer and Financials stocks:

Factor	Portfolio Exposure	Benchmark Exposure	Relative Exposure	Factor Volatility	Share of Absolute Factor Variance	Share of Absolute Total Variance	Share of Relative Factor Variance	Share of Relative Total Variance
Market	90.39	99.97	-9.58	13.44	98.18	96.21	55.19	26.60
Size	13.32	-1.01	14.33	8.03	-0.91	-0.90	46.71	22.51
Health	7.68	13.09	-5.41	6.91	0.29	0.28	6.19	2.98
Technology	9.31	19.10	-9.79	5.80	-0.06	-0.06	4.16	2.00
Mining	1.54	0.63	0.91	15.61	-0.20	-0.19	1.76	0.85
Energy	3.93	5.67	-1.74	10.47	1.04	1.02	1.62	0.78
Consumer	27.11	23.04	4.08	3.91	-0.68	-0.66	1.53	0.74
Finance	21.48	18.92	2.56	5.48	-1.93	-1.89	1.49	0.72
Value	1.52	0.78	0.73	13.45	-0.04	-0.04	0.61	0.29

Scenario Analysis: 2000-2001 Outperformance

Given property and casualty industry’s under-weighting of Market and Technology, it would experience its highest outperformance in an environment similar to the 2001 technology crash. In this environment, industry’s systematic exposures would generate 2% outperformance:

Chart of the factor returns of the Property and Casualty Industry’s Aggregate Portfolio relative to Market during 2000-2001

2000-2001: Stress test of outperformance due to Property and Casualty Industry’s Portfolio Factor Exposures

Below are the main contributors to this outperformance, in percent:

Factor	Return	Portfolio Exposure	Benchmark Exposure	Relative Exposure	Portfolio Return	Benchmark Return	Relative Return
Technology	-36.83	9.31	19.10	-9.79	-3.96	-7.99	4.04
Market	-29.28	90.39	99.97	-9.58	-26.75	-29.27	2.52
Consumer	19.60	27.11	23.04	4.08	5.03	4.26	0.77
Finance	27.27	21.48	18.92	2.56	5.48	4.81	0.66
Value	42.82	1.52	0.78	0.73	0.58	0.30	0.28
Mining	32.25	1.54	0.63	0.91	0.47	0.20	0.28

Scenario Analysis: 1999-2000 Underperformance

Given property and casualty industry’s under-weighting of Market and Technology, it would experience its highest underperformance in an environment similar to the 1999 technology boom. In this environment, industry’s systematic exposures would underperform the market by more than 10%:

Chart of the factor returns of the Property and Casualty Industry’s Aggregate Portfolio relative to Market during 1999-2000

1999-2000: Stress test of underperformance due to Property and Casualty Industry’s Portfolio Factor Exposures

Below are the main contributors to this underperformance, in percent:

Factor	Return	Portfolio Exposure	Benchmark Exposure	Relative Exposure	Portfolio Return	Benchmark Return	Relative Return
Technology	53.04	9.31	19.10	-9.79	4.30	8.95	-4.66
Market	29.23	90.39	99.97	-9.58	26.22	29.22	-3.00
Size	-18.83	13.32	-1.01	14.33	-2.63	0.20	-2.83
Consumer	-16.57	27.11	23.04	4.08	-4.72	-4.02	-0.70
Finance	-20.59	21.48	18.92	2.56	-4.54	-4.01	-0.54
Energy	14.38	3.93	5.67	-1.74	0.62	0.90	-0.27
FX	6.84	-3.74	-1.19	-2.55	-0.25	-0.08	-0.17
Value	-14.04	1.52	0.78	0.73	-0.17	-0.09	-0.08
Mining	-8.54	1.54	0.63	0.91	-0.08	-0.03	-0.05
Communications	0.52	1.30	2.06	-0.76	0.02	0.04	-0.01

Conclusions

There is factor (systematic/market) crowding of property and casualty insurance companies’ long U.S. equity portfolios.
The main sources of systematic crowding are short (underweight) exposures to Market (Beta), Technology, and Health.
Since year-end 2013, factor exposures have cost the property and casualty industry over 4%, more than $12 billion, in underperformance.
For some portfolios, this may be a conscious risk management decision; for others, it is a costly oversight.
By managing its exposures in recent quarters, the industry would have generated billions in additional returns.

The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2015, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.

Hedge Fund Crowding Update – Q1 2015

Identifying Hedge Fund Crowding

This piece follows the approach of our earlier articles on crowding: We created a position-weighted portfolio (HF Aggregate) consisting of popular long U.S. equity holdings of all hedge funds tractable from quarterly filings. We then analyzed HF Aggregate’s risk relative to U.S. Market Aggregate (similar to the Russell 3000 index) using AlphaBetaWorks’ Statistical Equity Risk Model to identify sources of crowding.

Hedge Fund Aggregate’s Risk

The Q1 2015 HF Aggregate had 3.1% estimated future tracking error relative to U.S. Market. Factor (systematic) bets were the primary source of risk and systematic crowding increased slightly from Q4 2014:

The components of HF Aggregate’s relative risk on 3/31/2015 were the following:

Source	Volatility (%)	Share of Variance (%)
Factor	2.42	61.21
Residual	1.92	38.79
Total	3.09	100.00

The low estimated future tracking error indicates that, even if its active bets pay off, HF Aggregate will have a hard time earning a typical fee. Consequently, the long portion of highly diversified hedge fund portfolios will struggle to outperform a passive alternative after factoring in the higher fees.

Hedge Fund Factor (Systematic) Crowding

Below are HF Aggregate’s principal factor exposures (in red) relative to U.S. Market’s (in gray) as of 3/31/2015:

Chart of the current and historical exposures to the most significant risk factors of U.S. Hedge Fund Aggregate

Factor Exposures Contributing Most to the Relative Risk for U.S. Hedge Fund Aggregate

Of these bets, Market (Beta) and Oil are responsible for almost 90% of the relative factor risk and 50% of the total. These are the components of the 2.42% Factor Volatility in the first table:

Chart of the cumulative contribution to relative factor variance of the most significant risk factors of U.S. Hedge Fund Aggregate

Factors Contributing Most to Relative Factor Variance of U.S. Hedge Fund Aggregate

Factor	Relative Exposure (%)	Portfolio Variance (%²)	Share of Systematic Variance (%)
Market	14.91	3.83	65.58
Oil Price	2.48	1.37	23.46
Industrial	9.38	0.46	7.88
Finance	-6.10	0.29	4.97
Utilities	-2.80	0.28	4.79
Other Factors		-0.39	-6.68
Total		5.84	100.00

Absolute exposures to all three primary sources of factor crowding are at or near 10-year highs.

Hedge Fund U.S. Market Factor Exposure History

HF Aggregate’s market exposure is near 115% (Beta is near 1.15) – the level last reached in mid-2006:

Chart of the historical U.S. Market Factor exposure of U.S. Hedge Fund Aggregate

U.S. Hedge Fund Aggregate’s U.S. Market Factor Exposure History

We will discuss the predictive value of this indicator in later posts. Note that long hedge fund portfolios consistently take 5-15% more market risk than S&P500 and other broad market benchmarks. Therefore, simple comparison of long hedge fund portfolio performance to market indices is generally misleading.

Hedge Fund Oil Price Exposure History

HF Aggregate’s oil exposure of 2.5% is similarly near 10-year highs and near the levels last seen in 2009:

Chart of the historical Oil Price factor exposure of U.S. Hedge Fund Aggregate

U.S. Hedge Fund Aggregate’s Oil Price Exposure History

As oil prices collapsed in 2014, hedge funds rapidly boosted oil exposure. This contrarian bet began to pay off in 2015. A comprehensive discussion of HF Aggregate’s historical oil factor timing performance is beyond the scope of this piece.

Hedge Fund Industrial Factor Exposure History

HF Aggregate’s industrials factor exposure over 25% is now at the all-time height:

Chart of the historical Industrial Factor exposure of U.S. Hedge Fund Aggregate

U.S. Hedge Fund Aggregate’s Industrial Factor Exposure History

This has been a losing contrarian bet since 2014.

Hedge Fund Residual (Idiosyncratic) Crowding

About a third of hedge fund crowding is due to residual (idiosyncratic, stock-specific) risk. Only four stocks were responsible for over half of the relative residual variance:

Chart of the cumulative contribution to relative residual variance of the most significant residual (stock-specific, idiosyncratic) bets of U.S. Hedge Fund Aggregate

Stocks Contributing Most to Relative Residual Variance of U.S. Hedge Fund Aggregate

These stocks will be primary drivers of HF Aggregate’s and of the most crowded firms’ stock-specific performance. Investors should be ready for seemingly inexplicable volatility in these names. Some may be wonderful individual investments, but most have historically underperformed:

Symbol	Name	Exposure (%)	Share of Idiosyncratic Variance (%)
VRX	Valeant Pharmaceuticals International, Inc.	4.13	29.75
LNG	Cheniere Energy, Inc.	1.72	15.06
SUNE	SunEdison, Inc.	0.80	3.51
CHTR	Charter Communications, Inc. Class A	1.54	2.84
PCLN	Priceline Group Inc	1.26	2.27
MU	Micron Technology, Inc.	0.86	1.99
ACT	Actavis Plc	1.68	1.94
EBAY	eBay Inc.	1.46	1.70
BIDU	Baidu, Inc. Sponsored ADR Class A	0.86	1.52
PAGP	Plains GP Holdings LP Class A	1.40	1.35

When investing in these crowded names, investors should perform particularly thorough due-diligence, since any losses will be magnified if hedge funds rush for the exits.

Historically, consensus bets have done worse than a passive portfolio with the same risk. Consequently, fund allocators should thoroughly investigate hedge fund managers’ crowding to avoid investing in a pool of undifferentiated bets destined to disappoint.

AlphaBetaWorks’ analytics assist in both tasks: Our sector crowding reports identify hedge fund herding in each equity sector. Our fund analytics measure hedge fund differentiation and identify skills that are strongly predictive of future performance.

Summary

There is both factor (systematic/market) and residual (idiosyncratic/security-specific) crowding of hedge funds’ long U.S. equity portfolios.
Hedge fund crowding is approximately 60% systematic and 40% stock-specific.
The main sources of systematic crowding are Market (Beta), Oil, and Industrials.
The main sources of idiosyncratic crowding are VRX, LNG, SUNE, and CHTR.
Allocators and fund followers should pay close attention to crowding: The crowded hedge fund portfolio has historically underperformed its passive alternative – investors would have made more by taking the same risks passively.

The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2015, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.

Hedge Fund Crowding – Q4 2014

Identifying Hedge Fund Crowding

This piece follows the approach of our earlier articles on fund crowding: We created a position-weighted portfolio (HF Aggregate) consisting of popular long U.S. equity holdings of all hedge funds with medium to low turnover that are tractable from quarterly position filings. We then analyzed HF Aggregate’s risk relative to U.S. Market (Russell 3000) using AlphaBetaWorks’ Statistical Equity Risk Model to identify sources of crowding. More background information and explanations of the terms used below are available in those earlier articles.

Hedge Fund Aggregate’s Risk

The Q4 2014 HF Aggregate had 3.0% estimated future annual tracking error relative to U.S. Market. Risk was primarily due to factor (systematic) bets:

The components of HF Aggregate’s relative risk on 12/31/2014 were the following:

Source	Volatility (%)	Share of Variance (%)
Factor	2.23	56.32
Residual	1.96	43.68
Total	2.97	100.00

Systematic risk increased by a tenth from the previous quarter. We will see the factors behind this increase below.

With an estimated future tracking error near 3%, HF Aggregate continues to be nearly passive. HF Aggregate will have a very hard time earning a typical fee. Investors in a broadly diversified portfolio of long-biased hedge funds will likely struggle also.

Hedge Fund Factor (Systematic) Crowding

Below are HF Aggregate’s principal factor exposures (in red) relative to U.S. Market’s (in gray) as of 12/31/2014:

Chart of the factor exposures contributing most to the relative factor (systematic) risk of U.S. Hedge Fund Aggregate

Factor Exposures Contributing Most to the Relative Risk of U.S. Hedge Fund Aggregate

Of these bets, Market (Beta) and Oil are responsible for over 80% of the factor risk relative to U.S. Market. These are the main components of the 2.23% Factor Volatility in the first table:

Chart of the factors contributing most to the relative factor (systematic) variance of U.S. Hedge Fund Aggregate

Factors Contributing Most to Relative Factor Variance of U.S. Hedge Fund Aggregate

HF Aggregate has become more systematically crowded since Q3 2014. The following factors were the top contributors to the relative systematic risk on 12/31/2014:

Factor	Relative Exposure (%)	Portfoio Variance (%²)	Share of Systematic Variance (%)
Market	13.26	3.10	62.37
Oil Price	2.23	1.01	20.32
Finance	-7.49	0.43	8.65
Industrial	9.53	0.35	7.04
Utilities	-3.36	0.26	5.23
Other Factors		-0.18	-3.62
Total		4.97	100.00

The increased factor risk during Q4 2014 was primarily due to a 2% increase in U.S. Market Exposure (Beta). After adding long oil exposure in Q3 2014 as the energy sector selloff intensified, hedge funds kept it steady through Q4.

Hedge Fund Residual (Idiosyncratic) Crowding

Turning to HF Aggregate’s residual variance relative to U.S. Market, eight stocks were responsible for over half of the relative residual risk:

Chart of the stocks contributing most to the relative residual (idiosyncratic) variance of U.S. Hedge Fund Aggregate

Stocks Contributing Most to Relative Residual Variance of U.S. Hedge Fund Aggregate

These stocks will be the primary drivers of HF Aggregate’s and of the most crowded firms’ returns. They will also be affected by the vagaries of capital flows into and out of hedge funds. Investors should be ready for seemingly inexplicable volatility in these names. They may be wonderful individual investments, but history is not on their side, since crowded bets have historically underperformed.

The list is mostly unchanged from the previous quarter:

Symbol	Name	Exposure (%)	Share of Idiosyncratic Variance (%)
LNG	Cheniere Energy, Inc.	1.70	15.73
AGN	Allergan, Inc.	3.53	9.51
VRX	Valeant Pharmaceuticals International, Inc.	2.35	9.18
CHTR	Charter Communications, Inc. Class A	1.80	3.88
HTZ	Hertz Global Holdings, Inc.	1.37	3.35
EBAY	eBay Inc.	1.91	3.27
MU	Micron Technology, Inc.	1.08	3.21
BIDU	Baidu, Inc. Sponsored ADR Class A	1.22	3.14
PCLN	Priceline Group Inc	1.29	2.43
SUNE	SunEdison, Inc.	0.63	2.29

When investing in these crowded names, investors should perform particularly thorough due-diligence, since any losses will be magnified when hedge funds rush for the exits.

AlphaBetaWorks’ analytics assist in both tasks: Our sector crowding reports identify hedge fund herding in each equity sector. Our fund reports measure hedge fund differentiation and skills that are strongly predictive of future performance.

Summary

There is both factor (systematic/market) and residual (idiosyncratic/security-specific) crowding of hedge funds’ long U.S. equity portfolios.
Hedge funds have become more systematically crowded during Q4 2014, primarily by increasing their Beta.
The main sources of idiosyncratic crowding are: LNG, AGN, VRX, CHTR, HTZ, EBAY, and MU.
The crowded hedge fund portfolio has historically underperformed its passive alternative. Investors would have made more by taking the same risk passively – hedge fund investors should pay close attention to crowding before allocating capital.

The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2015, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.

Sectors Most Exposed to USD FX

2 Replies

Currencies are major drivers of other assets. In periods of Foreign Exchange (FX) volatility, there is much discussion of its impact on specific equity sectors. Regrettably, market noise obscures true industry-specific performance, so FX impact is impossible to judge from simple index returns. But, by stripping away market effects, we observe relationships between pure sector returns and exchange rates:

Oil Drillers have the largest negative correlation with USD and one of the largest negative exposures.
Retailers have the highest positive correlation and one of the highest positive exposures.

Below we identify sectors most exposed to USD FX volatility and quantify these relationships.

Pure Sector Performance

As we illustrated earlier, market noise obscures relationships among individual sectors; it also conceals industry-specific performance. Without separating pure industry-specific returns from the market, robust risk management, performance attribution, and investment skill evaluation are impossible. When stripped of market effects, pure sector factors capture sector-specific trends and risks, including sector-specific USD exposures.

Equity Market’s USD FX Exposure

In addition to industry-specific foreign currency exposures, the equity market is significantly correlated with the currency market. Broad macroeconomic risks affect both exchange rates and the equity market. Below we plot U.S. Market returns against USD returns:

Chart of the correlation between USD FX and U.S. Equity Market

USD FX and U.S. Market Return Correlation

The beta of the U.S. Equity Market to USD FX is approximately -1.1: Over the past five years, when USD appreciated by 1% relative to a basket of foreign currencies, the U.S. Equity Market decreased by approximately 1.1%. USD FX variance explains approximately 38% of U.S. market variance. Perhaps more accurately, 38% of U.S. market variance is due to shared macroeconomic variables that drive both equities and currencies.

The exposure of an individual stock to USD FX is a combination of market, sector, and idiosyncratic effects.

Sectors Most Negatively Exposed to USD FX

Sectors with the highest negative correlation to USD are not surprising:

Chart of the correlation between pure sector factors and USD FX for the sectors most negatively correlated with USD FX

Pure Sector Factors Most Negatively Correlated with USD FX

Sector	USD FX Correlation	USD FX Correlation p-value	USD FX Beta	USD FX Beta p-value
Contract Drilling	-0.45	0.0002	-1.01	0.0006
Integrated Oil	-0.39	0.0011	-0.56	0.0011
Coal	-0.36	0.0021	-1.10	0.0004
Oilfield Services Equipment	-0.34	0.0042	-0.69	0.0059
Information Technology Services	-0.30	0.0109	-0.27	0.0373
Oil and Gas Production	-0.27	0.0174	-0.44	0.0131

(Note that we use the Spearman’s rank correlation coefficient to evaluate correlations. Spearman’s correlation is robust against outliers, unlike the commonly used Pearson’s correlation. All correlations are significant; most at a 1% level or better.)

Oil Price USD FX Exposure

Commodity industries’ (oil, coal, etc) exposure to USD FX is due to their macroeconomic sensitivity, inflation sensitivity, and the global nature of the commodity markets. When USD strengthens, USD-denominated commodity prices have to decline in order for broad currency-weighted prices to remain unchanged. Consequently, commodity prices tend to be strongly negatively correlated with USD FX:

Chart of the correlation between historical USD FX returns and Oil Price returns

USD FX and Oil Price Return Correlation

The Oil Price’s beta to USD FX is -1.9: Over the past five years, when USD appreciated by 1% relative to a basket of foreign currencies, the Oil Price decreased by approximately 1.9%. 30% of Oil Price variance is explained by the shared macroeconomic variables that drive both commodity and currency markets.

Information Technology Sector USD FX Exposure

Information Technology Services is a typical export industry that suffers margin compression when USD-denominated costs increase relative to foreign-currency-denominated revenues. However, our analysis indicates this exposure is barely statistically significant with the beta’s p-value of 0.04. This exposure is also low: a 1% increase in USD FX is associated with approximately 0.3% decrease in the value of the sector.

Sectors Most Positively Exposed to USD FX

The list of sectors with the highest positive correlation to USD FX is less intuitive:

Chart of the correlation between USD FX returns and the returns of pure sectors factors most positively correlated with it

Pure Sector Factors Most Positively Correlated with USD FX

Sector	USD FX Correlation	USD FX Correlation p-value	USD FX Beta	USD FX Beta p-value
Real Estate Investment Trusts	0.29	0.0121	0.39	0.0101
Pulp and Paper	0.30	0.0102	0.52	0.0123
Aerospace and Defense	0.31	0.0084	0.32	0.0206
Beverages Alcoholic	0.33	0.0049	0.43	0.0025
Catalog Specialty Distribution	0.33	0.0045	0.41	0.0349
Department Stores	0.37	0.0020	0.70	0.0085

The list is dominated by import-sensitive sectors that benefit from a boost in U.S. consumer purchasing power from an appreciating USD. Also, when the USD appreciates, the associated drop in import prices boosts aerospace and defense companies, likely due to depreciating foreign inputs.

The presence of REITs on the list appears unexpected. Yet, it is due to the same shared variables as the negative correlation between REITs and oil prices: inflation, growth rates, and macroeconomic uncertainty.

Conclusion

Industry-specific performance is clouded by market noise.
By stripping away the effects of market and macroeconomic variables, we reveal the performance of Pure Sector Factors and their relationships with USD FX.
Commodity producers and information technology exporters most consistently suffer from appreciating USD.
Importers and retailers most consistently benefit from appreciating USD.

The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2015, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.

Smart Beta and Market Timing

2 Replies

Why Returns-Based Style Analysis Breaks for Smart Beta Strategies

Smart beta (SB) strategies tend to vary market beta and other factor exposures (systematic risk) over time. Consequently, market timing is an important source of their risk-adjusted returns, at times more significant than security selection. We have previously discussed that returns-based style analysis (RBSA) and similar methods fail for portfolios that vary exposures. Errors are most pronounced for the most active funds:

Estimates of a fund’s historical and current systematic risks may be flawed.
Excellent low-risk funds may be incorrectly deemed poor.
Poor high-risk funds may be incorrectly deemed excellent.

Due to the variation in Smart Beta strategies’ exposures over time, returns-based methods tend to fail for these strategies as well.

Three Smart Beta Strategies

We analyze the historical risk of three SB strategies as implemented by the following ETFs:

Low Volatility Indexing – PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV)
Fundamental Indexing – PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF)
Quality Indexing – PowerShares S&P 500 High Quality Portfolio ETF (SPHQ)

SPLV indexes 100 stocks from the S&P 500 with the lowest realized volatility over the past 12 months. PRF indexes the largest US equities based on book value, cash flow, sales, and dividends. SPHQ indexes the constituents of the S&P 500 with stable earnings and dividend growth.

All three smart beta strategies varied their factor exposures including their market exposures.

Low Volatility ETF (SPLV) – Market Timing

The low-volatility smart beta strategy has varied its market exposure significantly, increasing it by half since 2011. As stocks with the lowest volatility – and their risk – changed over time, the fund implicitly timed the broad equity market. The chart below depicts the market exposure of SPLV over time:

Chart of this historical U.S. market exposure of the low volatility smart bet (SB) strategy as implemented by PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV)

PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) – Historical U.S. Market Exposure

Low Volatility ETF (SPLV) – Historical Factor Exposures

SPLV’s market exposure fluctuates due to changes in its sector bets. Since the market betas of sectors differ from one another, as sector exposures vary so does the fund’s market exposure:

Chart of the historical exposures to significant risk factors of the low volatility smart bet (SB) strategy as implemented by PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV)

PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) – Significant Historical Factor Exposures

Low Volatility ETF (SPLV) – Returns-Based Analysis

The chart below illustrates a returns-based analysis (RBSA) of SPLV. A regression of SPLV’s monthly returns against U.S. Market’s monthly returns estimates the fund’s U.S. Market factor exposure (beta) at 0.50 – significantly different from the historical risk observed above:

Chart of the regression of the historical returns of PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) against the Market

PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) – Historical Returns vs. the Market

This estimate of beta understates SPLV’s historical market beta (0.55) by a tenth and understates current market beta (0.70) by more than a third. RBSA thus fails to evaluate the current and historical risk of this low volatility smart beta strategy. Performance attribution and all other analyses that rely on estimates of historical factor exposures will also fail.

Fundamental ETF (PRF) – Market Timing

The market risk of the Fundamental ETF has been remarkably constant, except from 2009 to 2010. Back in 2009 PRF increased exposure to high-beta (mostly financial) stocks in a spectacularly prescient act of market timing:

Chart of the historical exposures of the fundamental smart beta (SB) strategy as implemented by the PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) to U.S. and Canadian Markets

PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) – Historical Market Exposure

Fundamental ETF (PRF) – Historical Factor Exposures

The historical factor exposure chart for PRF illustrates this spike in Finance Factor exposure from the typical 20-30% range to over 50% and the associated increase in U.S. Market exposure:

Chart of the exposures of the fundamental smart beta (SB) strategy as implemented by the PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) to significant risk factors

PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) – Significant Historical Factor Exposures

This 2009-2010 exposure spike generated a significant performance gain for the fund. PRF made approximately 20% more than it would have with constant factor exposures, as illustrated below:

Chart of the historical return from market timing (variation in factor exposures) of the PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF)

PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) – Historical Risk-Adjusted Return from Market Timing

By contrast, PRF’s long-term risk-adjusted return from security selection is insignificant:

Chart of the historical returns from security selection (stock picking) of the PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF)

PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) – Historical Risk-Adjusted Return from Security Selection

Factor timing turns out to be more important for the performance of some smart beta strategies than security selection.

Fundamental ETF (PRF) – Returns-Based Analysis

A returns-based analysis of PRF estimates historical U.S. market beta around 1.05:

Chart of the regression of the returns of PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) against the U.S. Market

PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF) – Historical Returns vs. the Market

This 1.05 beta estimate only slightly overstates the fund’s current and historical betas, but misses the 2009-2010 exposure spike. Returns-based analysis thus does a decent job evaluating the average risk of a fundamental indexing smart beta strategy, but fails in historical attribution.

Quality ETF (SPHQ) – Market Timing

The market exposure of the quality smart beta strategy (SPHQ) swung wildly before 2011. It has been stable since:

Chart of the U.S. and Canadian Market exposures of the quality smart beta (SB) strategy as implemented by the PowerShares S&P 500 High Quality Portfolio ETF (SPHQ)

PowerShares S&P 500 High Quality Portfolio ETF (SPHQ) – Historical Market Exposure

Quality ETF (SPHQ) – Historical Factor Exposures

As with the other smart beta strategies, market timing by SPHQ comes from significant variations in sector bets:

Chart of the historical exposures of the quality smart beta (SB) strategy as implemented by the PowerShares S&P 500 High Quality Portfolio ETF (SPHQ) to significant risk factors

PowerShares S&P 500 High Quality Portfolio ETF (SPHQ) – Significant Historical Factor Exposures

Quality ETF (SPHQ) – Returns-Based Analysis

A returns-based analysis of SPHQ estimates historical U.S. market beta around 0.86:

Chart of the regression of the historical returns of PowerShares S&P 500 High Quality Portfolio ETF (SPHQ) against the U.S. Market

PowerShares S&P 500 High Quality Portfolio ETF (SPHQ) – Historical Returns vs. the Market

Given the large variation in SPHQ’s risk over time, this 0.86 beta estimate understates the average historical beta but slightly overstates the current one. While the current risk estimate is close, RBSA fails for historical risk estimation and performance attribution.

Conclusions

Low volatility indexing, fundamental indexing, and quality indexing smart beta strategies vary market and other factor exposures (systematic risk) over time.
Due to exposure variations over time, returns-based style analysis and similar methods tend to fail for smart beta strategies:
- Funds’ historical systematic risk estimates are flawed.
- Funds’ current systematic risk estimates are flawed.
- Performance attribution and risk-adjusted performance estimates are flawed.
Analysis and aggregation of factor exposures of individual holdings throughout a portfolio’s history with a capable multi-factor risk model produces superior risk estimates and performance attribution.

The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
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