Views from the CIO: Out of the Shadows – Systematic Solutions

 

Nasdaq ETF Picture

On March 22, Principal launched two new ETFs on the NASDAQ (see image). My Global Systematic Solutions team is responsible for managing the U.S. Price Setters Index ETF (PSET) and U.S. Shareholder Yield Index ETF (PY), the first two ‘smart beta’ (or ‘strategic beta’) funds on the Principal ETF platform.

‘Smart beta’ and ‘strategic beta’ is being thrown around a lot these days.  We prefer the term ‘strategic beta’ to ‘smart beta’, but the terms can be used synonymously. New products are being launched regularly, and promoted as the new and superior solution to both passive cap-weighted index replication and active management.  But, what is it?  Is it passive?  Is it active?  What are the benefits to an investor? Diversification? Cost? Better beta?

Why has Principal and Principal Global Equities launched strategic beta strategies and entered the ETF market?  What competitive advantages do we have over the competition?  What products have been launched?  While addressing some of these questions below, I also encourage you also to take a look at our ETF offerings at principaletfs.com, as well as our Global Systematic Solutions capabilities and team at principalglobal.com for more information.

 

What is strategic beta? Is it passive or active?

First, any investment strategy deviating from a cap-weighted index is, by definition, active.  Strategic beta is merely an unbundling of traditional active management investment processes into more discreet risk premia (betas). While sharing similarity to passive approaches by typically following rules-based execution, smart beta strategies are still actively managed and should be treated as such. The distinction between what is traditionally viewed as an actively managed and strategic beta fund can be distilled down to which active manager skill set dominates.

An active manager can add value through two main skills: generating excess return through their investment research and/or through portfolio construction and execution. The last two decades have seen a virtually exclusive focus on the former as evidenced by the high alpha/high conviction/concentrated portfolio movement.  Relegated to the shadows a bit has been the focus on portfolio construction.  However, strategic beta has rekindled the long lost art (and importance) of portfolio construction.

Given less (or no) focus on alpha in strategic beta strategies, the success of such to do better than a cap-weighted benchmark is dependent upon the manager’s portfolio construction skill.  The range of portfolio construction approaches seen in current smart beta managers moves from naïve (equally weighted) to sophisticated (principal component and optimization), passing through the just plain questionable (cap-weighted).  As a result, we fully expect strategic beta investors investing in similar strategies to experience very different outcomes based on the skill of their manager to construct a portfolio that can mirror the return of the underlying risk premia purportedly being exploited.

But even portfolio construction can mask the most basic building block of any smart beta strategy: how to measure the beta exposure itself.  It amazes us how little discussion occurs on this most fundamental topic.  If you are exploiting the “value” risk premia, your first question is “which definition of value”? Price to book, price to earnings, price to cash flow, dividend yield – the list goes on.  Then we move into the realm of data sources, robustness, smoothing or statistical techniques used to measure a stock’s exposure to the desired risk premia.  Additionally, many smart beta solutions lack sophistication that adequately considers liquidity.  The natural extreme is attempting to capture the size risk premium, which, by its very definition, is liquidity constrained.

Properly managed, we do believe smart beta strategies provide investors with more granular instruments to better tailor their portfolios to achieve their desired investment objectives at a more attractive cost point and with greater transparency.  These are key benefits of any unbundling exercise.  The question on whether they are more effective, however, will largely be dependent on the skills of the underlying strategic beta manager.  With continued evolution, it is possible that we may see strategic beta strategies replace more traditional “core” actively managed funds.

 

Why Principal and Principal Global Equities?

For more than 25 years, Principal Global Equities has been managing active fundamental and systematic solutions across equity markets worldwide. An early pioneer seamlessly integrating advanced quantitative research and analysis with traditional fundamental research and due diligence to exploit our bottom-up, earnings-focused stock selection expertise, we have a notable history of highly sophisticated and proprietary quantitative capabilities. Make no mistake, we continue to maintain a laser focus and discipline in the management of our active fundamental strategies, while providing additional capabilities along the equity investment spectrum for our clients.

The interactions, influences, and experience of the fundamental business provides us with key competitive advantages in developing and managing strategic beta.  Particularly, we are focused on the next evolutionary stage of strategic beta; that is, moving beyond portfolio construction, and adding alpha to beta through investment research, the active manager skill currently neglected by many strategic beta providers.  We believe we can add innovative and differentiated products that benefit investors in the strategic beta market and the rapidly growing and increasingly crowded ETF market by:

 

  • developing better proxies for risk premia;
  • establishing better ways of combining multiple risk premia; and
  • creating reliable methodologies for timing allocations to the various risk premia.

 

What strategic beta solutions have been launched?

We launched two passively managed ETFs, U.S. Price Setters Index ETF (PSET) and U.S. Shareholder Yield Index ETF (PY), on March 22. We have also launched multiple solutions under our active Dynamic systematic suite including international, U.S. value, and U.S. all-cap equity strategies.

 

There are many potential uses and benefits of strategic beta solutions including: obtaining better exposure to securities that have a particular feature, or group of features; the potential for excess returns; typically low costs as the result of systematic and rules-based execution; and the list goes on. In some cases, the combination of strategies beta strategies or ETFs can provide even better risk-adjusted results.

 

About PSET

PSET seeks to provide investors a “quality growth” outcome by investing in companies we systematically identify to have the potential of sustainable pricing power, quality growth, profitability, and the ability to maintain profit margins and earnings even during difficult environments such as high inflation or during deflationary periods.  Read more about PSET here.

 

About PY

PY seeks to boost an investors’ total yield and income potential beyond dividend yield alone. Dividend yield outperforms in most declining interest rate environments; and, while interest rates have been on the decline since 1990, dividend yield carries an interest rate risk such that investors may be disappointed if/when interest rates rise in the future. Investors in PY can benefit from a broader, more sustainable yield than just dividend yield alone, taking into consideration share repurchases and capital allocation decisions, thereby helping to mitigate the effects of interest rate risk of dividend yield alone.  Read more about PY here.

 

Our Commitment

Just as with any actively managed strategy, a strategic beta manager’s skill will be critical to achieving desired outcomes. By moving beyond the focus on portfolio construction, we believe smart beta outcomes can be taken to another level and we are committed to bringing creative and innovative ideas helping to solve our clients’ investment problems.

Happy Investing!

 

 

 

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Glossary

Alpha: the performance of an investment against a market index

Beta: a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Dividend yield: ratio indicating how much a company pays out in dividends each year relative to its share price

Price to book: ratio used to compare a stock’s market value to its book value, calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.

Price to cash flow: ratio of a stock’s price to its cash flow per share.

Price to earnings: ratio for valuing a company that measures its current share price relative to its per-share earnings.

Risk premium: the return in excess of the risk-free rate of return that an investment is expected to yield

The information in this article has been derived from sources believed to be accurate as of April 2016. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.

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The Principal Shareholder Yield Index ETF seeks to provide investment results that closely correspond, before expenses, to the performance of the NASDAQ U.S. Shareholder Yield Index. The ETF employs a passive investment approach designed to track the performance of the Index. The NASDAQ U.S. Shareholder Yield Index is a NASDAQ-licensed index based on The Principal Financial Group®’s intellectual property (IP). The Principal® retains ownership of the index IP under the licensing agreement. The index provides exposure to equity securities of mid- and large-capitalization U.S. issuers. The index focuses on U.S. companies with sustainable shareholder yield, strong cash flow generation, and capacity to increase dividends and/or buybacks. Total expense ratio for PY is 0.40%.

The Principal Price Setters Index ETF seeks to provide investment results that closely correspond, before expenses, to the performance of the NASDAQ U.S. Price Setters Index. The ETF employs a passive investment approach designed to track the performance of the Index.The NASDAQ U.S. Price Setters Index is a NASDAQ-licensed index based on The Principal Financial Group®’s intellectual property (IP). The Principal® retains ownership of the index IP under the licensing agreement. The index provides exposure to equity securities of mid- and large-capitalization U.S. issuers. The index focuses on U.S. companies with sustainable pricing power, consistent sales growth, high/stable margins, quality earnings, low leverage, and high levels of profitability. Total expense ratio for PSET is 0.40%.

RISKS – Asset allocation and diversification do not ensure a profit or protect against a loss. Investing in ETFs involves risk, including possible loss of principal. ETFs are subject to risk similar to those of stocks, including those regarding short-selling and margin account maintenance. Equity investments involve greater risk, including heightened volatility, than fixed-income investments.

This Fund is new and has limited operating history. ETFs can be tax efficient in that they are exchange-traded and redeem creation units from authorized participants by using redemptions in kind, which are not taxable transactions for the Fund. However, capital gains are still possible in an ETF, and if you reinvest the earnings of the ETF, you may owe taxes on your funds even if you didn’t sell any shares, potentially eating into your returns. Investor shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Ordinary brokerage commissions apply.

ALPS Distributors, Inc. is the distributor of the Principal Edge Active Income ETF. ALPS Distributors, Inc. and Principal Funds are not affiliated.

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Asset allocation and diversification do not ensure a profit or protect against a loss. Investing involves risk, including possible loss of principal.

Principal Funds are distributed by Principal Funds Distributor, Inc.
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