Commentaries

PMC Weekly Review - January 16, 2015

A Macro View – Investing Beyond Beta

Equity markets enter 2015 riding a string of six consecutive yearly gains. The S&P 500 has gained more than 156% over that period in a relatively low volatility environment, making it difficult for active managers to have outperformed the benchmarks. While the pendulum will inevitably swing back in favor of active management, perhaps coincident with a general rise in market volatility, the central theses behind passive investing – obtaining efficient exposure to the primary drivers of investment return and diversification – will remain in place irrespective of the market environment.

Because traditional active managers have performed so poorly relative to the benchmarks over the past several years there has been an increasing emphasis placed on so-called “smart beta” strategies, wherein the typical market capitalization-weighting of constituents in traditional indexes is tweaked to provide superior returns without active security selection. A prime example of such smart beta approaches includes equal-weighting the indexes. There are many other such strategies that focus on overweighting high-dividend stocks, and other approaches using fundamental data.

Over the past few decades there has been a significant body of academic research conducted which have identified key drivers of investment return. These return factors, often called style premia because they tend to generate excess returns, include momentum, value, profitability and illiquidity, among others. Constructing portfolios with active weights to these factors, rather than individual securities, has been shown to generate excess returns over time. So, while the portfolios are actively managed, the active management focuses on maintaining exposures to the selected return factors rather than individual securities.

Investing “beyond beta” – focusing not only on obtaining cost-efficient exposure to return-driving factors, but also on tax-management alpha and customization – can serve to enhance a portfolio’s total and risk-adjusted returns.

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Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

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Brandon Thomas
Chief Investment Officer

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