Many investors and advisors may not be aware of the hidden consequences of smart beta portfolios that use factor-only approaches but don’t consider concentration risks or the impact of turnover.

Parametric Portfolio Associates launched this summer a series of U.S. and international factor strategies aimed at tackling these hidden consequences.

Part of the firm’s “Custom Core” strategies, Parametric’s factor-based portfolios are constructed using active risk controls to deliver exposure to popular factors while managing risk, costs and unintended exposures.

The strategies are designed to be implemented in tax-efficient separate accounts with a minimum of $250,000.

Paul Bouchey, Parametric chief investment officer, recently discussed these two problems (turnover and unintended risks) and how Parametric is addressing them in its new strategies.

First up, the impact of excessive turnover leading to transaction costs and taxes.

“There’s always trading that has to happen in these smart beta and factor-based investing strategies,” Bouchey explained at a media event on Tuesday in New York. “That obviously comes with transaction costs, which can eat away into an investor’s return.”

For taxable investors especially, Bouchey said, trading costs can be huge.

“If you sell something that’s appreciated, you have to pay a capital gains tax,” he said. “It’s almost like upwards of half of your returns can go to the government. And if you’re talking about small equity returns to begin with and small extra excess returns from your strategy, this can completely destroy the value added.”

Bouchey called this a big problem, adding “I don’t think that’s been discussed enough in the industry.”

In order to limit the transaction costs of turnover, Parametric has limited itself to an annual reconstitution.

“Once a year, we have to update to make sure the quality’s still in the portfolio and there will be some turnover there,” Bouchey said. “But we can do some things to reduce the turnover, and one of the key things is don’t trade every month or every quarter.”

Next up is the unintended risks and factor exposures that come with many factor-only approaches.

While factor risk premia (such as value, size, momentum, profitability and low beta) are the source of the extra returns generated by smart beta indexes, they can also have unintended consequences.  

For example, an investor who wants to focus on value, or stocks trading at low valuations relative to the market, may not realize that indexes that focus on value tend to be invested in unprofitable companies.

“If I was in a value index, I’d be extraordinarily disappointed over the last five years, most likely,” Bouchey said. “Some of this disappointment doesn’t necessarily come from the value investing risk premium. It comes from the fact that values of the portfolio over the last five years tended to be overweight energy stocks, which went through a recent crisis. Or have been significantly tilted toward unprofitable companies. A tilt toward energy, a tilt toward unprofitable companies – these were not the intended exposures that the investor or managers were seeking. They wanted inexpensive stocks.”

To reduce unintended bets and isolate risk factor premia, Parametric is using “active risk controls” as part of its new factor strategies. “One of the most cutting-edge things that is happening in the development of smart beta right now is attempting to apply risk controls to avoid these unintended events,” Bouchey said.

Investors can select from Parametric’s factor portfolios that seek to maintain a systematic bias toward certain factors, such as dividend yield, value, quality, momentum, low volatility, profitability and size. These strategies are then optimized to maximize the intended factor exposures while reducing unintended factor, sector and security bets. 

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