The volatility and turbulence in share markets this year are more of a sign that the business cycle has matured rather than a sign that the world is heading into recession, said a leading market expert.
Mr Matthew Peron, executive vice-president and managing director of global equity at Northern Trust Asset Management, which offers services such as wealth and asset management, told The Sunday Times: "It's more of a regime change in the market. People like to blame it on various things, but what's really happening is we're moving along the business cycle where, from the lows, we've put in a lot of stimulus into the system - both fiscal and monetary - and we're generally removing a lot of that stimulus.
"So the markets need to stand on their own and that transition typically introduces volatility as markets want to settle in."
Northern Trust had US$117 billion (S$157.8 billion) in banking assets, US$6.1 trillion in assets under custody and US$875 billion in assets under management as of Dec 31.
The firm uses what are called "smart beta" indexing strategies for managing investments in order to help ride out such volatility.'
These are alternative strategies that do not use market capitalisation-based indices as a benchmark.
The New York Times described them as seeking higher returns - without having to pick stocks actively - by creating "investment portfolios based on other measures, such as a stock's volatility, or a company's dividends, sales or cash flow".
Some Northern Trust retail funds using such strategies include the FlexShares Quality Dividend Index Fund, which has had an average annualised total return of 14.51 per cent over three years, and the Northern Small Cap Value Fund, which has had annualised return of 11.69 per cent over the same period.
Q What is your take on global markets?
A We're in a market calibration right now, and that can be volatile. Our view is that we won't have a global recession. Emerging markets will certainly have difficult times, and even though global growth will be lower than we'd like to see, it will not necessarily deteriorate as much as the markets were implying in the February sell-off.
Q How are funds that use smart beta strategies different from the traditional funds?
A Typically, funds will have a manager selecting individual stocks, or if they are an index fund, they will just buy the whole market - weighting purchases based on market capitalisation.
Funds that use smart beta strategies are in between. Like an index fund, they still buy a very large number of stocks, but they'll target specific groups of stocks that fit a particular profile - for example, value stocks or growth stocks - rather than just buying according to market capitalisation.
These profiles are known as risk factors or factor tilts. You'll see more and more of this type of strategies in the coming years, so it's good for investors to be aware of these strategies and the pitfalls. We offer these strategies mostly to institutional investors, and in the United States, we offer it to institutional, high-net-worth and retail investors.
Q What should retail investors know about smart beta indexing strategies, which could be used to ride out this market volatility?
A Retail investors should be careful when employing a smart beta strategy or fund, and ensure that they are not in too many or too narrow niches. However, if you're thoughtful about it, you can improve your long-term outcomes by tailoring a programme of factor tilts towards your specific risk profile and time horizon.
Factor tilts are really about segmenting the market. For instance, in fixed income, you have government, corporate and high-yield bonds, and you can also segment equity markets, which smart beta does.
Some smart beta strategies make sense for retail investors, such as value strategies that may be for the younger or more aggressive investor, or low-volatility strategies that might be better for an older or more risk-averse investor.
A low-volatility strategy for a fund means it has a safer risk profile and could deliver a smoother outcome with less chance of surprises, which is very important to people approaching retirement.
For instance, emerging markets have sold off double digits in the last three months or so. A low-volatility emerging markets strategy fund should have sold off considerably less.
The low-volatility strategy won't gain all the benefits if markets go up quickly, but they will be more protective in down markets. Over a long period of time, that can accrue to an investor's benefit because studies have shown that avoiding the downside is very positive for your long-term returns.
Value strategies tend to have a higher risk, but higher returns, if you have a long-term horizon.
They can have very pronounced down periods, which is why they give you larger returns over long periods of time. If you can be patient and have a high risk tolerance, and take mark-to-market markdowns, you can benefit from such a strategy.
Q What is one major pitfall of using smart beta strategies?
A They could be not robust enough or too simplistic. For example, a fund might focus on a value strategy that also has other risks in it, such as being concentrated in only one sector, like banks or something like that. Unless you researched it, you wouldn't know - it might be pitched as a value fund but really it is all banks.
Q When did smart beta strategies start getting popular and why?
A In the market, "smart beta" took off as a term about three or four years ago. First, the idea of index investing became very popular among retail investors as the combination of low fees and huge diversification appealed to people.
Smart beta strategies then became popular when people started to realise that there are other ways to look at the equity markets, in particular, that don't involve stock picking but are more targeted to individuals' objectives.
Northern Trust has been constructing such portfolios for more than 20 years, so things didn't change for us.
The impetus behind the growth in smart beta is healthy and makes a lot of sense, but you'd want to make sure "the cure is not worse than the disease".
Use these strategies to your advantage but make sure you do a lot of research on a particular strategy, that the intellectual property that is backing the strategy has a long history and is thoughtful.
Q How often are portfolios rebalanced when using smart beta strategies?
A If you are strategic at the outset, you shouldn't have to rebalance it too often. You can generally leave it for a few years, evaluate and then reassess it every few years.
For our target date or retirement products, where we combine smart beta strategies together with your age, we will change the weightings every five years.
We recommend a value strategy for younger investors because they can take the volatility and hopefully benefit from excess returns.
As they age, every five years we shift more of their portfolio from value to low volatility - and that's a strategy that could be useful for retail investors here.
This article was first published on April 3, 2016.
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