Blackrock Smart Beta Guide en Au PDF

FOR PROFESSIONAL CLIENTS/QUALIFIED
INVESTORS/SOPHISTICATED INVESTORS ONLY
SMART BETA
GUIDE
SMART BETA
GUIDE
“Factors are the language
of investing that everyone
should be speaking.
Smart beta is the vehicle
to deliver factor investing.”
Andrew Ang, PhD

Head of BlackRock’s Factor Based Strategies Group,
Author of Asset Management: A Systematic Approach
to Factor Investing
[2] FORE WORD
Foreword
If you are an investor, whether you are the CIO of a large pension fund or an individual
saving for retirement, you should care about factors. Why? Because factors are what drive
the risk and return in your portfolio. The ability to harness factors appropriately can ensure
your investments are working to meet your goals.
In the simplest form, factors are broad, historically persistent drivers of return. These
sources of return are intuitive and well-understood by the marketplace. They are expected
to endure over the long term because they are rewarded for bearing risk, or they arise
through structural impediments or behavioural biases.
Factor investing is a framework that can produce superior diversification, return

enhancements relative to traditional market capitalisation benchmarks, and, done at its
best, becomes an empowering way to manage an entire asset management firm. I have
studied factor investing in academia – as a student and as a professor – for over 20 years,
and have worked with many institutional investors to put factor investing into practice.
Since my advisory work with the Norwegian sovereign wealth fund in 2009, I have seen an
explosion of interest in this space. I believe wide adoption of factor investing will transform
the asset management industry and the way we all think about our investments.
Just as runners must understand and rely upon the nutrients in their food to ensure they
have the energy to run a marathon, investors can employ specific factors to achieve unique
and personal investment objectives, such as reducing the overall risk of a portfolio, or
enhancing long-term returns.
Factor investing captures these drivers of returns, taking advantage of investment

intuition, diversification and efficient execution. Today, with the introduction of smart beta
strategies, all investors can gain access to many of the same time-tested investment ideas
that have been present in actively managed portfolios for decades, in a transparent and
rules-based vehicle and at a lower cost than traditional active management.
With a growing number of smart beta providers and offerings emerging in the marketplace,
where should an investor turn for help?
I joined BlackRock because I believe this firm is the leader in the factor investing space.
Backed by decades of investment expertise in systematic strategies, industry-leading
research and analytics, and unparalleled execution capabilities, BlackRock is the partner
to help you assess which factors you own, which factors you want to own and how best to
employ specific strategies like smart beta to achieve your unique goals.
This guide is designed to simplify the key considerations behind the investment concept
by providing investors with a deeper look into the what, why and how of smart beta.
I hope this desk reference will be a comprehensive resource as you begin to explore
the potential of factor investing.
I am a true advocate of factor investing and I believe smart beta is THE way we can
empower all investors to access these sources of returns in a simple and affordable way.
S M A R T B E TA G U I D E [3]
[4] S M A R T B E TA G U I D E
TABLE OF CONTENTS
FOREWORD 3
SECTION 1: UNDERSTANDING SMART BETA 6

Defining smart beta 8
Why investors should explore smart beta 10
The rationale for factor-based investing 13
Factor index construction essentials – MSCI 16
Smart beta in numbers 20
SECTION 2: ASSESSING SMART BETA 22

Smart beta strategy evaluation and due diligence 24
Smart beta attribution and challenges 26
Factor behaviour in changing economic environments – MSCI 31
SECTION 3: IMPLEMENTING SMART BETA 34

Implementing smart beta in portfolios 36
Investor case study – CLS Investments, LLC 51
Smart beta beyond equities 53
ACKNOWLEDGEMENTS 60
S M A R T B E TA G U I D E [ 5 ]
SECTION 1: UNDERSTANDING SMART BETA
SECTION 1
Defining smart beta

If you open the pages of the Financial Times or a Bloomberg magazine,
chances are that you will come across an article about smart beta. One of the
fastest growing segments in the financial industry, smart beta has become
a ubiquitous theme in investment management today. But is smart beta just
another buzzword or marketing invention?
An overview of smart beta’s history

The expression smart beta is new but the concepts behind it are not.
Fundamentally, smart beta has its roots in factor investing, itself the subject of
long-standing academic research. Its roots go back as far as the 1960s, when
William F. Sharpe identified risk factors as the primary drivers of equity returns.
Factor investing seeks to identify and capture broad, persistent drivers of

return. It is the formalisation of, for example, the idea of seeking inexpensive
companies (value investing) or high quality balance sheets (quality investing) –
intuitive investment styles that have long been part of the active management
toolkit. Smart beta strategies aim to capture these return drivers through rules-
based, transparent strategies. They are benchmark-driven versions of factor
strategies, generally long only and usually implemented within an asset class.
The objectives of smart beta

Smart beta strategies aim to improve returns, reduce risks and enhance
diversification. Yet, while exposure to certain factors has been historically
rewarded over the long term, factors are not immune to changes throughout
the market cycle. The return of any individual factor may be positive or negative
in a particular month or year. Over a sufficiently long period of time however,
long-term investors can be rewarded for their exposure to factors.
FIGURE 1: WHAT SMART BETA IS AND WHAT IT IS NOT
What smart beta is What smart beta is not
Captures well-understood
Subjective oversight
drivers of return
Objective rules Proprietary
Transparent Novel
High capacity Nuanced
[8] U N D E R S TA N D I N G S M A R T B E TA
SECTION 1
Active, passive or something in between

A common question surrounding smart beta is if these strategies are active INVESTOR
or passive. The truth lies somewhere in between. Smart beta strategies are INSIGHT:
active in that they attempt to enhance risk-adjusted returns through exposures If you explain
to proven drivers of return. At the same time, these strategies resemble
smart beta to
traditional passive strategies in that their implementation is transparent,
me, it is the same
systematic and rules-based. This means that portfolio construction is
as if you explain
based upon a set of rules that are widely disclosed and require little or no
discretionary input from portfolio managers. These strategies tend to have medicines. I’m
lower fees and higher capacity than traditional active strategies. only interested
in what they do,
The table below maps smart beta against both traditional capitalisation
weighted indices and actively managed strategies across defining meaning, what’s
characteristics to explain smart beta’s similarities to both. the outcome?
Dutch Private Bank
FIGURE 2: COMPARING CHARACTERISTICS ACROSS PASSIVE,
ACTIVE AND SMART BETA STRATEGIES
Long Only
Cap-weighted Smart Actively

indices beta managed
Exposure to
High High High
macro factors
Exposure to
Low Moderate Moderate
style factors
Potential for Moderate

None Moderate
outperformance to high
Turnover and Moderate

Low Low
trading costs to high
Liquidity and Low to

High High
capacity moderate
Transparency High High Low
Source: Smart Beta: Defining the Opportunity and Solutions, BlackRock, 2015.
KEY INSIGHT: Smart beta strategies aim to capture drivers

of return through rules-based, transparent strategies. They
are benchmark-driven versions of factor strategies, generally
long only and usually implemented within an asset class.
SECTION 1
Why investors should explore smart beta

The investment community’s interest in smart beta is hard to ignore.
The reason lies in the potential benefits to investors:
`Ìmproved portfolio outcomes

``Reduction of portfolio cost
`Ìncreased transparency
Improved portfolio outcomes

Figure 3 illustrates the historical risk and return of several equity factors
including value (seeking inexpensive stocks), momentum (following trend),
and yield (seeking income) compared to the standard MSCI World Index.
FIGURE 3: RISK AND RETURN OF MSCI FACTOR INDICES
14%
Momentum
13%
Risk Weighted
ANNUALISED RETURN
High Dividend Yield

Equal Weighted (Size)
12%
Quality Value Weighted
Minimum Volatility
11%
MSCI World
10%
11% 12% 13% 14% 15% 16% 17%
ANNUALISED RISK
Performance of MSCI World based indices, USD, (28 November 1975 – 30 June 2015).
Source: BlackRock and MSCI as of June 2015. Past performance is not a reliable indicator of future performance.
An individual investment strategy or product may appear attractive in isolation

but investments should never be evaluated in a vacuum. Deploying smart beta
within a portfolio context allows an investor to understand the full potential of
these strategies.
The following table illustrates several iterations of a 60% equity and 40%
fixed income portfolio invested in US equity and fixed income assets.
The ‘Base Line’ portfolio is invested in capitalisation weighted indices for
equity and fixed income. The ‘Lower Volatility’ portfolio seeks to reduce
total volatility relative to the ‘Base Line’ market portfolio, while the ‘Seek
Outperformance’ portfolio looks to outperform the ‘Base Line’ portfolio.
[10 ] U N D E R S TA N D I N G S M A R T B E TA
SECTION 1
Access to minimum volatility equity, multi-factor equity and balanced risk

fixed income strategies (which seek an equal contribution to risk from
rates and credit) allows investors flexibility to develop portfolios to meet
a range of outcomes.
FIGURE 4: THREE PORTFOLIOS FOR US EQUITIES AND

US FIXED INCOME
Investment Seek
outcome Base line Lower volatility outperformance
60% MSCI USA

60% MSCI USA
60% MSCI USA Diversified
Minimum Volatility
Allocation 40% Barclays US Multiple Factor
40% US FI
Aggregate 40% US FI
Balanced Risk
Balanced Risk
Total annualised
5.65% 6.54% 8.13%
return
Total annualised
8.87% 7.55% 9.76%
risk
Return to risk
0.64 0.87 0.84
ratio
Max drawdown* -31.29% -26.46% -33.52%
Source: BlackRock and MSCI as of June 2015. Past performance is not a reliable indicator of
future performance.
* Max drawdown is the peak-to-trough decline during a specific period of an investment.
December 1998 – June 2015. Portfolios are rebalanced semi-annually.
FIGURE 5: PORTFOLIO PERFORMANCE COMPARISON

400
350
CUMULATIVE RETURN
300
250
200
150
100
50
0
Jun 99 Jun 01 Jun 03 Jun 05 Jun 07 Jun 09 Jun 11 Jun 13 Jun 15
60% MSCI USA 60% MSCI USA Minimum Volatility 60% MSCI USA Diversified Multiple Factor
40% Barclays US 40% US FI Balanced Risk 40% US FI Balanced Risk
Aggregate (Base Line) (Lower Volatility) (Seek Outperformance)
Source: BlackRock and MSCI as of June 2015. Past performance is not a reliable indicator of future performance.
S M A R T B E T A G U I D E [ 11 ]
SECTION 1
Reduction of portfolio cost

After-fee performance and weighted portfolio cost continue to drive investment
decisions. Index based investments have gathered a tremendous volume of
assets over the last decade as investors shift portfolios to more cost-effective
structures. Smart beta strategies allow investors to seek enhanced risk-
adjusted returns at a lower cost than active strategies while retaining many
of the benefits of investing in traditional index strategies. Generally speaking,
INVESTOR the cost of smart beta strategies lies between traditional index strategies and
INSIGHT: active strategies.
Now, our
philosophy is
45 % ofhavetheexpense
all about ‘are
~800 smart beta ETPs globally
we exposed to
the right factors’, ratios below 50bps
whilst previously
Source: BlackRock, as of August 2015.
it was still about
stock selection,
alpha and
Increased transparency
these types
Transparency is a defining attribute of smart beta strategies. Like traditional
of things.
index strategies, smart beta strategies follow pre-set rules to determine the
Dutch Private Bank process for security selection, portfolio construction and rebalancing. The
rules are not adjusted for changing market conditions. Often those rules are
published by a third-party benchmark provider. The level of transparency
means investors should have full knowledge of construction rules and portfolio
characteristics, thereby enhancing their ability to make informed allocations
and build more diversified portfolios. Armed with a clear view of the delivered
exposures, investors can be more informed about how a strategy is likely to
perform in various market regimes.
KEY INSIGHT: Smart beta allows investors to:

improve portfolio outcomes
reduce portfolio costs
increase performance transparency
[ 12 ] U N D E R S T A N D I N G S M A R T B E T A
SECTION 1
The rationale for factor-based investing

Factor investing looks beyond traditional asset class labels to target true
economic drivers of return such as economic growth or inflation, as well as
proven investment characteristics such as value or momentum. A factor-based
lens can help investors better understand their portfolios, can enable better
risk management and, ultimately, can increase the probability of achieving
defined investment goals.
Understanding drivers of risk and return

Factors are to assets what nutrients are to food – both milk and steak contain
fat and protein – just as economic risk is present in public equities, private
equities, high yield bonds and most hedge funds. So, while healthy eaters look
through the foods they eat to identify the nutrients they contain, factors allow
us to cut across asset classes and identify the true sources of risk and return.
Finding the right mix of assets requires an understanding of the economics

of these underlying factors. With a better understanding of these return drivers,
investors can build more robust and diversified portfolios.
FIGURE 6: FACTOR EXPOSURE MATTERS

TRADITIONAL MOST BASIC
BROAD UNIVERSE
CATEGORIES ELEMENTS
Bread
Muffins Cheese Pudding Nutrients
Onions Corn Ice Cream
Salad
Steak Broccoli Fibre 65% Understanding the
Jam Rice Radishes
Oranges Chicken Fish DAIRY MEAT Protein 25% nutritional content
Carrots Eggs Beans
Peas drives decisions around
Ham Cereal
Milk Carbohydrates <1%
Pasta VEG. FRUIT what foods you eat
Potatoes Apples Peppers Fat 10%
Mushrooms Strawberries
Sweets Pastry Grapefruit GRAINS Sodium <1%
Domestic Equity Real Estate

Diversified Credit Large Cap Risk Factors
Commodities Farmland Understanding drivers
Event Driven Small Cap REITs Value 120 bps of market returns allow
Synthetic Overlay Direct Lending ALTS
Momentum 75 bps investors to build more
ETFs Timber TIPS
Risk Parity Smart Beta VALUE GROWTH diversified portfolios
Inflation 53 bps
Emerging Markets Private Equity EQUITY EQUITY and make better
Leveraged Loans Real Return Economic Growth 620 bps investment decisions
Core Fixed Income Cash
Energy FIXED INCOME Currency / FX 12 bps
Hedge Funds
Factors are the fundamental

building blocks of
investment returns
For illustrative purposes only.

Source: BlackRock, as of September 2015.
SECTION 1
Equity factor research tends to be much more prevalent than that for other
asset classes, although many of these characteristics persist across other
asset classes as well. Certain factors have positive expected total returns
over the long run, driven by the powerful forces that shape risk preferences,
investor behaviour and market structure. Macro-economic risk factors capture
non-diversifiable risks that have exhibited positive expected return over longer
periods, compensating investors for bearing those risks. For example, holding
nominal bonds exposes the investor to the risk of inflation and the risk of real
rates rising. Within asset classes, there are also commonalities among securities
which we refer to as style factors. Certain (not all) style factors have historically
delivered a positive expected return over the long term as a result of a structural
impediment or behavioural anomaly that shapes the preferences of investors.
Risk factors – both macro and style – can be captured in transparent, rules-
based portfolios. Only active managers can successfully deliver true alpha, and
alpha is only (persistently) positive for managers with skill.
Behavioural, risk and structural factor categories

Factors can persist due to the following:
``Behavioural biases – the psychological aspect of investment decisions

``Risk premia – a market-risk based explanation
``Structural impediments – obstructions to investors not always addressed
in academic research, such as taxes, long-only constraints etc.
FIGURE 7: SOURCES OF PORTFOLIO RISK AND RETURN
Macro risk factors

Non-diversifiable risks that } Economic } Real rates
have exhibited positive } Credit } Liquidity
MACRO expected return over
} Inflation } Emerging
longer periods
markets
STYLE
Style risk factors
Capturing a risk premium } Value } Low volatility
that has historically } Momentum } Carry
ALPHA delivered a return premium
} Quality } Curve
over the long term
} Size } Convexity
Alpha
Positive alpha requires } Security selection
manager skill } Country and industry selection
} Market and factor timing
Source: BlackRock Smart Beta: Defining the Opportunity and Solutions, February 2015.
SECTION 1
Investors define factors in a number of ways, meaning that categorisations

can differ. INVESTOR
INSIGHT:
Value is possibly the most recognised and studied equity style factor dating
As our
back to when market participants began to evaluate companies’ prices relative
expectations
to their intrinsic value. The most prevalent explanations for the long-term
for the market
return premium associated with this factor relate to the amount of risk an
investor must bear and the compensation that must accompany this risk. beta premium
Investors allocate to value with less information certainty, which increases lowered following
their business risk. Bearing this risk has led to long-term excess returns for the financial
value investors. crisis, we looked
for additional
Value investing can be characterised as being a contrarian decision. Can you
sources of alpha.
allocate to cheap stocks, be prepared to endure the difficult times and be
compensated in a proportionate manner for the risk taken? This happened
3 years ago and
The concepts in equity smart beta can be extended to other asset classes. is the reason
Certain factors can be applied across a range of assets; there is evidence that
why we started
momentum works across equities, fixed income, currencies and commodities.
risk premium
Others can be more specific to a specific asset class, such as duration in fixed
investing.
income. A more detailed overview of smart beta across assets is presented in
the section ‘Smart beta beyond equities’. Asian Sovereign
Wealth Fund
KEY INSIGHT: Factors are to assets what nutrients

are to food. Rewarded factors are derived from
behavioural, risk and structural considerations.
S M A R T B E TA G U I D E [15 ]
SECTION 1
Factor index construction essentials

This chapter explains important considerations
in the construction of MSCI factor indices.
Factors in academic models and active management

Equity factor investing was pioneered based on research, data and analytics
developed by Barra – today part of MSCI. The most widely recognised
multi-factor model was developed in the early 1990s by Eugene Fama and
Ken French. It explains US equity market returns with three factors: the market,
the size factor (large vs small capitalisation stocks) and the value factor
(low vs high book to market). In 1997, Carhart extended the Fama-French model
to include a momentum factor.
EXHIBIT 1: BUILDING BLOCKS OF MSCI FACTOR INDICES

Systematic factor What it captures Common measures
Value Excess returns from stocks that Book to price, earnings to price, book
have low prices relative to their value, sales earnings, cash earnings,
fundamental value. net profit, dividends, cash flow.
Small size Excess returns of smaller firms Market capitalisation (full or free float).
(Small cap) (by market capitalisation) relative to
their larger counterparts.
Low volatility Excess returns from stocks with lower Standard deviation (1, 2 and 3 year),
than average volatility, beta and/or downside standard deviation, standard
idiosyncratic risk. deviation of idiosyncratic returns, beta.
High yield Excess returns of stocks that have Dividend yield.

higher-than-average dividend yields.
Quality Excess returns from stocks that are Return on equity, earnings stability,
characterised by low debt, stable dividend growth stability, strength
earnings growth and other ‘quality’ of balance sheet, financial leverage,
metrics. accounting policies, strength of
management, accruals, cash flows.
Momentum Excess returns from stocks with strong Relative returns (3, 6 and 12 month),
past performance. historical alpha.
Source: MSCI.
SECTION 1
Factors used in MSCI indices

MSCI’s approach to factor investing is to identify risk factors that have a solid
foundation in financial theory and have been shown to provide a systematic
risk-adjusted return premium (i.e., more return per unit of risk or less risk
per unit of return). We believe that these factors respond to longer-term
macroeconomic forces (some pro-cyclical and some defensive) in which they
provide historical outperformance over long periods of time versus the broad
market, but they also experience periods of underperformance that can
discourage short-term investing. Examples of these factors are Value,
Small Size, Low Volatility, High Yield, Quality and Momentum.
MSCI factor indices are designed to provide a way for passive investors to
capture risk-adjusted return premia that previously have been available only
to active managers.
MSCI index construction

An index’s ability to capture better risk-adjusted returns than the overall
market is tied to the way it is designed and maintained. MSCI indices are
strictly rules based – which makes them consistent and highly transparent.
We publish details about index methodology and constituents on our website
to ensure that investors know what to expect from our indices.
Our factor indices are based on our overall approach to index construction,
an approach we have developed and continuously tested over more than four
decades. An important consideration in constructing a factor index is the
trade-off between exposure and investability. High-exposure factor indices
such as MSCI Momentum Indices have higher investability constraints than
‘optimised’ factor indices such as MSCI Minimum Volatility Indices. Another
consideration is a factor index’s weighting scheme.
Investability
Because the largest institutional investors in the world use our indices, we
have embedded strong controls into our index construction process to ensure
that our indices are highly investable and liquid. Investability requirements
are applied at the overall company level – such as full company market
capitalisation represented by the aggregation of all eligible listed and unlisted
securities of a company – and at the individual security level, such as free
float-adjusted market capitalisation and liquidity measures.
Our framework for assessing investability has four components: (1) Tradability/
Liquidity, (2) Turnover/Cost of Replication, (3) Capacity and (4) Degree of Active
Tilt. The table overleaf defines each component and provides examples of ways
we measure it.
SECTION 1
EXHIBIT 2: FRAMEWORK FOR ASSESSING INVESTABILITY

Category What it measures Metrics
Tradability/ How liquid the stocks are in the portfolio } Weighted average annualised traded
Liquidity and how tradable the portfolio is. value ratio
} Days to trade (relative to benchmark,
periodic rebalancing)
} Days to complete 95% of trading
(relative to benchmark, periodic
rebalancing)
Turnover/ The turnover of the index at } Index turnover

Cost of replication rebalancing. This metric scales with } Performance drag
costs: the higher the turnover, the
higher the cost of trading.
Capacity For a given size fund, the percentage } Stock ownership (percentage of float
of a stock’s free float or full market market cap)
capitalisation the fund would own. } Stock ownership (percentage of full
market cap)
Degree of Degree to which a factor index deviates } Active share

active tilt from the capitalisation-weighted } Average weight multiplier
index. In so far as the capitalisation- } Maximum weight multiplier
weighted index represents what is most } Maximum strategy weight
investable, the degree of active tilt is } Active target factor exposure
also a way to assess investability.
Source: MSCI.
Weighting scheme
The weighting scheme used in constructing an index determines its exposures.
The main objectives are to maximise exposure to the target factors, maximise
investability and reduce turnover (and hence rebalancing costs).
Factor indices can be classified into high exposure and high capacity. High
exposure indices are designed to maximise exposure to the target factor
while staying within MSCI’s investability guidelines. High capacity indices
are designed to allow very large investments into the index and to focus on
maximising investability and reducing turnover.
MSCI has high exposure and high capacity versions of each of its six single-factor
indices. High exposure indices are constructed by selecting a subset of stocks from
the universe, based on a ranking methodology (typically z scores). High capacity
indices use the entire universe but tilt the weights toward the target factor.
There are two possible weighting schemes for high capacity indices, and both
use the entire universe.
``The first is a ‘score only’ approach, which takes descriptors and calculates
the score of each stock based on the descriptors. The stock’s weight in the
index is then simply the stock score divided by the sum of the score of all
stocks. Our risk weighted indices follow this methodology.
SECTION 1
``The second approach is ‘score times market cap’, where the market cap of
each stock is multiplied by its score. A stock’s weight is simply the market cap
times score divided by the sum of the market cap times the score of all stocks.
The ‘score only’ approach gives a higher exposure to the target factor but
can lead to significant active weights. In the case of the risk weighted index,
this would mean an exposure to small cap stocks because the descriptor is
variance. Compared to market cap, variance is more stable from stock to stock.
‘Score times market cap’ naturally takes the factor index closer to market cap,
increases exposure to large cap stocks (and hence systematic outperformance)
and also increases investability compared to ‘score only’.
The chart below illustrates the differences in the high capacity weighting
schemes, ‘score only’ and ‘score times market cap’.
EXHIBIT 3: WEIGHTS FOR MSCI WORLD LOW VOLATILITY INDICES

2.5%
2.0%
WEIGHT IN INDEX
1.5%
1.0%
0.5%
0.0%
0 150 300 450 600 750 900 1,050 1,200 1,350 1,500 1,650
SECURITIES IN THE INDEX
Score only (Risk Weighted) Score x mcap (Low Volatility Tilt) Mcap (World Index)
Source: MSCI.
The x axis shows all stocks ranked in ascending order of market cap and the
y axis shows the weights in the respective indices. The dark blue line shows the
pure market cap index, MSCI World Index. The green line shows the ‘score times
market cap’ approach and the light blue line shows the ‘score only’ approach.
The difference between the ‘score only’ and ‘score times market cap’ is
significant and leads to some small cap exposure. It is important to note that
other factors will behave differently.
Conclusion
MSCI’s factor indices aim to provide a systematic risk-adjusted return
premium by achieving a specified high level of exposure to targeted factors.
MSCI currently offers factor indices that target six factors: Value, Small Size,
Low Volatility, High Yield, Quality and Momentum. Important considerations
in constructing these indices are the trade-off between exposure and
investability, and the index’s weighting scheme.
SECTION 1
SMART BETA IN NUMBERS

FIGURE 8: GLOBAL SMART BETA ETP ASSETS: $230BN AS OF SEPTEMBER 2015
300 ANNUAL ASSET YTD FLOWS

$BN GROWTH ($19.7BN)
250
1 20% 0.3
18 46% 2.7
200 24 121% 7.7
33 32% 3.7
150
44 49% 5.9
100
108 23% -0.6

50
0
Mar 12 Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Mar 15 Sep 15
Dividend Multi Factor Equal Weight Minimum Volatility Single Factor Fixed Income
Source: BlackRock as of 30 September 2015. Past performance is not a reliable indicator of future performance.
FIGURE 9: SMART BETA AVERAGE FIGURE 10: SMART BETA SHARE

ANNUAL ORGANIC GROWTH RATE* OF ASSETS BY LISTING REGION
AND CATEGORY
YTD Flows Assets
($BN) ($BN)
US 11.7 US 190.3
Europe 4.2 Europe 20.8
Canada 2.5 Canada 12.4
APAC 1.1 APAC 5.3
LatAm LatAm
0.2 0.8
& Iberia & Iberia
0% 25% 50% 0% 50% 100%
Dividend Equal Weight Single Factor

Multi Factor Minimum Volatility Fixed Income
* Since 2012 including YTD September 2015 annualised.

Source: BlackRock as of 30 September 2015. Past performance is not a reliable indicator of future performance.
[2 0 ] U N D E R S TA N D I N G S M A R T B E TA
SECTION
SECTION 11
Globally, the ratio is ~$1 in $12

flowing INVESTOR
into smart beta ETPs through September 2015 INSIGHT:
I see potential
for smart beta.
If the media
20BN 230BN
or investors
$ $ understand that
many active
2015 YTD smart beta ETP flows Total industry ETP flows exposures
can be easily
replicated with
smart beta ETFs,
the potential
45 % of the ~800 smart beta ETPs globally

have expense ratios below 50bps
increases.
Credit Suisse
Year-by-year smart beta launches globally out of all ETPs since 2012:
16% 16% 30% 23%

2012: 2013: 2014: YTD September 2015:
87 of 545 85 of 522 184 of 619 124 of 533
global launches global launches global launches global launches
54 smart beta providers globally at the end

of 2012, rising to 59 in 2013, 80 in 2014 and
92 as of September 2015
Source: BlackRock as of September 2015.
SECTION 2: ASSESSING SMART BETA
SECTION 2
Smart beta strategy evaluation and due diligence

The smart beta landscape is a crowded space with many different strategies
available to investors. Differentiating between the available products can be a
challenging exercise. A systematic and logical way to approach smart beta due
diligence can help investors efficiently determine a strategy’s characteristics
and identify potential challenges.
INVESTOR A framework to evaluate smart beta strategies

INSIGHT: BlackRock’s suggestion is that following a six step process will enable investors
There is a lot to navigate between and successfully evaluate the different options available
of dialogue and to them so that they can achieve their intended outcome:
conversation
The steps are:
around the
importance 1 Clarify the investment goal
of knowing 2 Verify the merit and investability of the exposure
your smart beta
products. They
3 Evaluate potential performance in different market regimes
are not created 4 Understand the strategy’s construction rules
equal. You have
5 Consider in the context of your existing portfolio
to look past
the label on 6 Compare the costs of a product with its competitors
the tin.
EXS Capital
KEY INSIGHT: By following a systematic, logical

framework that utilises the evaluation techniques
of traditional index and actively managed strategies,
investors can understand the potential impact of a
chosen smart beta strategy and are more likely to
achieve their investment goals.
[2 4] A S S E S S I N G S M A R T B E TA
SECTION 2
FIGURE 11: FRAMEWORK FOR EVALUATING SMART BETA STRATEGIES

Action What should be considered Why this is relevant
Clarify the } Investors should be clear what their } If investors have a specific long
investment goal desired outcome is when selecting term performance, risk or style-
a smart beta strategy. orientation objective, finding the
}Are they looking to enhance the exposure they are looking for will
returns of their existing portfolio be more easily achieved.
or are they looking to alter the
risk profile?
Verify the merit } Are the factors well-researched and } Investors must carefully evaluate
and investability can investment in the strategy lead the economic reasoning driving the
of the exposure to value creation? factor return and determine whether
} Does the product adequately capture the exposure is consistent with their
the desired factor exposure? investment beliefs.
Evaluate potential } Investors should be aware of how } Factors with economic logic typically
performance in different factors respond to different reward investors in the long term in
different market market scenarios. exchange for taking risks that can
regimes lead to periods of underperformance
versus the broad market.
Understand } What metrics are used to select } An in-depth understanding of the
the strategy’s the index constituents? methodology enables investors to
construction rules } Check the number and weightings understand whether the strategy is
of constituents. designed using diversified metrics.
} What is the rebalance frequency, } There is a positive relationship
turnover and liquidity profile of the between turnover and cost.
underlying index used?
Consider in the } How does this strategy fit with the } Factors should be integrated into a
context of your rest of your portfolio? portfolio in the context of the overall
existing portfolio } Within your current portfolio, what risk-return objectives.
strategy/assets should you consider } Understanding your existing
replacing with a factor product? factor exposure will enable you to
} Is your selected strategy to take identify factors that complement
the place of an existing active or your existing portfolio.
passive investment?
Compare the } Cost of the strategy being considered. } The cost paid for the product is a key
costs of a } Cost of other products available to drag on ongoing investment returns.
product with its the investor. } Understanding the relationship
competitors between cost and investment returns
is an important consideration when
investing in a smart beta product.
Source: BlackRock.
INVESTOR INSIGHT:
Know your benchmark, make detailed comparisons to standard market-cap
benchmarks and understand the behaviours in various scenarios.
Credit Suisse
S M A R T B E TA G U I D E [2 5 ]
SECTION 2
Smart beta attribution and challenges

Assessing the components of returns through attribution
In a well-known paper, William Sharpe1 showed that, in aggregate, active
managers’ returns, net of costs, will underperform as a group. That said, active
management remains popular and there are undoubtedly talented managers
who have genuine skill in timing market turns or in security selection. For an
investor, the challenge is to identify the managers who have these talents.
Often investors equate alpha with excess returns over their stated benchmark,
but one can argue that this measure of value added is only part of the story.
INVESTOR To see this, consider a simple one factor model of equity returns where a
INSIGHT: stock’s return is proportionate to the market’s return. If the benchmark return
We take a very is represented by the market return, then managers may exceed the average
conservative return on the market only because they maintained a tilt to higher beta stocks
approach. over a period when the market as a whole rose. Such a static factor tilt could
We would be easily replicated with an ETF, meaning the manager should not receive high
compensation for such ‘outperformance’. A manager who successfully avoided
like to see a
downturns by moving to cash and conversely held the market in upturns,
thorough history.
however, would have genuine or true alpha accruing to their factor timing
Understanding it
abilities. The same is true of a manager who selected stocks that outperformed
is very important.
but otherwise maintained a beta of one to the market. That skill set deserves to
The critical be rewarded by investors.
question is:
An active manager’s return in excess of their benchmark can be broken down
‘Why should we
into three components:
get paid as an
investor and is ``Returns to static factor premia, such as a tilt to value or momentum stocks
it sustainable in ``Manager skill coming from factor timing
the future’? ``Manager skill coming from security selection
Dutch Private Bank Investors would ideally compensate a manager for timing and security
selection, recognising that static tilts can be gained at a low cost. But how
can we estimate these components? The decomposition of active returns
has traditionally been performed using regression analysis of returns, but
regression methods, while attractive in many dimensions, are potentially
misleading when factor weightings are dynamically changing. By contrast,
our approach here is based on actual holdings, which lets us identify the
covariation of changes in holdings with future excess returns – essentially
factor timing ability – and excess returns to stock selection.
1 Sharpe, William F., 1991. “The Arithmetic of Active Management,” The Financial Analysts Journal
Vol. 47(1), January/February, pages 7-9.
SECTION 2
Below is an extensive data set of quarterly equity holdings from 2005-2015

for all active US style box mutual funds (Figure 12). This lets us identify those
managers whose portfolio returns derive largely from tilts to known ‘smart
beta’ factors as opposed to genuine insights. One can conclude that there are
ways to identify managers with little or no skill (whose turnover and fees may
actually detract from returns) but who stay in business because they simply
maintain static bets.
FIGURE 12: ACTIVE RETURN ATTRIBUTIONS FOR US MUTUAL FUNDS

All US active style box mutual funds (1,267) Only funds with positive active return (352)
Active return Active return

(-89 bps) 112 bps
Static factor Manager skill Static factor Manager skill

premia (net of expenses) premia (net of expenses)
51 bps (-140 bps) 105 bps 7 bps
Factor timing Stock selection Factor timing Stock selection

20 bps (-160 bps) 24 bps (-17 bps)
Source: BlackRock, Bloomberg, Barra, Morningstar, Thomas Reuters, 30 June 2005 to 30 June 2015. Past performance is not
a reliable indicator of future performance.
The diagram shows average active return attributions for the set of 1,267
US active style box mutual funds, with $3.3 trillion in assets, based on quarterly
holdings data for the 10-year period from 30 June 2005 to 30 June 2015.
Active returns are calculated with respect to style box benchmarks defined
by Morningstar.2
KEY INSIGHT: Investors should pay active managers

who generate genuine alpha. Static factor tilts
however can be replicated more cost-efficiently
with a smart beta strategy.
2 See: “Smart Beta and Mutual Fund Performance Attribution,” by A. Madhavan, R. Nestor,
S. Shores, and A. Sobczyk.
SECTION 2
The potential challenges for smart beta strategies

The transparent nature of smart beta strategies naturally leads to questions
about whether or not the strategies’ advantages will become arbitraged away
by changes in securities’ prices over time and about whether the strategies can
become overcrowded.
Smart beta strategies, despite their transparent nature, are much less
susceptible to overcrowding and dilution by arbitrage than is commonly
believed. This is because:
``Smart beta strategies emphasise basic fundamental drivers of risk

and return.
``While factors are widely understood, the mix of securities underlying
them changes over time.
``Factors can be subtle. Security returns are influenced by a number
of forces and are never only one-dimensional.
INVESTOR Smart beta strategies are centred on factors that are thought to be deep,
INSIGHT: fundamental drivers of risk and return. By fundamental we mean that there are
Our main concern either behavioural or risk compensation drivers of return that are compelling
in applying from a logical, economic perspective and the persistence of which is supported
smart beta to our by the data over a long time frame and relating to diverse regions.
portfolio is the Smart beta strategies’ motivation by fundamental drivers makes them more
crowding effect. likely to endure when compared to active strategies, the focus of which is
Asian Sovereign superior information. The best example is value investing, which was well
Wealth Fund articulated by Graham & Dodd in 19343, but remains a key component of smart
beta strategies today. Value may succeed because investors chase ‘hot’ stocks
or because value drivers are correlated with macro-risks and hence yield
compensation for risk over time.
However, deep fundamental drivers are inevitably multi-dimensional and

can be somewhat subtle. For example, when asked to think of momentum,
investors are likely to think of a handful of high-flying basic materials or
technology names, whereas for value they are likely to think about a handful of
consumer staples or business services names. The fact is that risk factors are
the underlying return drivers of all securities in varying degrees of magnitude.
Therefore, gaining exposure to a factor is not only about owning a handful of

securities but rather about the relative weights across broadly-diversified
baskets of securities. It can be as much about underweighting or avoiding
those securities with low factor exposures as it is about overweighting or
emphasising those with high exposure to the particular factor, and about
updating those relative weights as prices move and markets evolve. Building
portfolios with high exposure to factors, while simultaneously minimising
3 Graham, Benjamin, David Le Fevre Dodd, and Sidney Cottle. Security analysis. New York:
McGraw-Hill, 1934.
SECTION 2
unintended bets in a dynamically changing environment, requires refined

factor metrics and a thoughtful rebalancing methodology.
So, while generally robust to the impact of arbitrage and crowding, investors
nonetheless need to be alert to the possibility of potential pressure on factors
and monitor the health of factors, including:
``Tracking relative valuation

``Tracking imputed flows
Monitoring the relative valuation of factors can help quantify the degree to
which factor investors may have affected prices. It is important to look at
relative valuation measures to control for inherent variation in valuation across
factors, and relative to the broad market. Figure 13 shows the price-earnings
ratio of several single-factor ETFs relative to their own history and relative to
an S&P 500 ETF, based on three years of data ending 31 August 2015.
FIGURE 13: PRICE-EARNINGS RATIO OF SINGLE FACTOR ETFs

P/E: Current valuation relative to a S&P 500 ETF and 3 year history
PERCENTAGE UNDER/OVER-VALUE RELATIVE TO IVV
80%
60%
40%
20%
0%
-20%
-40%
Value US Minimum Volatility Momentum Quality Size
3 Standard Deviation 1 Standard Deviation Mean Dec 2014 Mar 2015 Aug 2015
Source: BlackRock and MSCI, as of 31 August 2015. Past performance is not a reliable indicator of future performance.
The securities underlying factors are traded regularly by market participants

with a variety of motivations. The transparent nature of ETFs makes it possible
to attribute aggregate flows into individual securities which can then be
aggregated up into individual factors. We refer to this as ‘imputed flows’.
Figure 14 shows the cumulative imputed flows over a particular period into
the same single-factor ETFs relative to an S&P 500 ETF.
S M A R T B E TA G U I D E [2 9]
SECTION 2
FIGURE 14: CUMULATIVE IMPUTED FLOWS INTO SINGLE-FACTOR ETFs
0.5%
MARKET CAPITALISATION ANNUALISED FLOWS
0.4%
0.3%
0.2%
0.1%
0.0%
-0.1%
-0.2%
-0.3%
Aug 12 Feb 13 Aug 13 Feb 14 Aug 14 Feb 15 Aug 15
US Value Factor ETF US Minimum Volatility Factor ETF US Momentum Factor ETF
US Quality Factor ETF US Size Factor ETF
Source: BlackRock and MSCI, as of 31 August 2015.
Smart beta strategies are about gaining exposure to basic, fundamental

INVESTOR drivers of risk and return that underlie all securities. This sets them apart from
INSIGHT: strategies that rely on superior information which can often lead managers to
We are long- take concentrated positions in particular securities. For this reason, smart beta
strategies tend to have higher capacity than other types of active strategies.
term investors.
Patience is Over longer time frames, the fundamental drivers of risk and return could
necessary for change and factors could conceivably become crowded. Therefore, an
implementation. important component of any smart beta strategy involves monitoring the
Although health of factors which is achieved by tracking their relative valuation and
we evaluate estimating the aggregate flows into and out of representative factor portfolios.
investments These sorts of flow and valuation metrics will become increasingly important
as smart beta gains prominence in the market place.
month by month
and year by year,
we understand
you may need
KEY INSIGHT: Smart beta strategies are much less
3 years to
susceptible to overcrowding and dilution by arbitrage
capture the
than is commonly believed.
premium.
Asian Sovereign
Wealth Fund
[3 0 ] A S S E S S I N G S M A R T B E TA
SECTION 2
Factor behaviour in changing

economic environments
As our clients evaluate factor-based investment
strategies, they want to understand how
they will perform in different market regimes.
In response to this need, we have created a process for designing
macroeconomic-sensitive portfolios.
In both a short-term historical analysis and a long-run analysis using the MSCI
Macroeconomic and Asset Pricing Models, we found that MSCI factor indices
are different from each other with regard to their sensitivity to real economic
growth and inflation.
In addition, we found that although all factor returns have historically been
highly cyclical, their periods of underperformance have not been identical.
Some factors, such as Value, Momentum and Size have historically been
pro-cyclical, outperforming when economic growth and volatility are rising.
High Dividend, Quality and Minimum Volatility have been more defensive,
outperforming in a weak macro environment.
EXHIBIT 1: WHEN FACTORS HAVE HISTORICALLY OUTPERFORMED

Outperform in strong macro Outperform in weak macro
environments environments
Value High Dividend
Momentum Quality
Size Minimum Volatility
Classification based on short-term historical analysis

Equity factors can be classified as either pro-cyclical or defensive. Exhibit 2
below shows the correlation between the year-on-year relative performance
of factor indices versus their parent index and year-on-year change of the
corresponding OECD economic growth (CLI) Index, which measures the overall
state of the economy or point in the business cycle. The analysis is based on
returns from 1975 to December 2013, including simulated data.
EXHIBIT 2: MSCI WORLD CORRELATION WITH OECD CLI
Defensive Factors Correlation Pro-Cyclical Factors Correlation
Minimum Volatility -0.50 Equal Weighted 0.14
Quality -0.43 Value Weighted 0.05
High Dividend Yield -0.25 Momentum -0.11
Risk Weighted -0.19
SECTION 2
The correlation value illustrates the relationship between a specific factor and
the strength of the economy. For example, a correlation of -0.50 between the
Minimum Volatility Index and the CLI Index indicates that returns to Minimum
Volatility tend to be strong at times when the economy is weak. The defensive
nature of Minimum Volatility, Quality, High Dividend Yield and Risk Weighted
factor indices is clear in this analysis. However, the supposedly pro-cyclical
factor indices – Equal Weighted, Value Weighted and Momentum – are more
of a puzzle, with only the Equal Weighted index showing a meaningful positive
correlation to the CLI, and the sensitivity of the Momentum index actually
appearing to be negative.
We found that adding a second variable such as inflation (CPI) helps to explain
performance in these cyclical indices.
Examining short-term index performance in different periods

The chart below shows the differential performance of factor indices in
periods in which economic growth and inflation are rising or falling separately.
Higher returns are shown in green and lower returns are in blue.
EXHIBIT 3: MONTHLY GROSS ACTIVE RETURNS
Economic Growth (CLI) Inflation (CPI)
MSCI World Index Decreasing Increasing Decreasing Increasing
Equal Weighted 0.0% 0.3% 0.2% 0.0%
High Dividend Yield 0.2% 0.1% 0.2% 0.2%
Minimum Volatility* 0.3% -0.3% 0.0% 0.1%
Momentum 0.2% 0.3% 0.2% 0.3%
Quality 0.3% -0.1% 0.0% 0.2%
Risk Weighted 0.2% 0.2% 0.2% 0.1%
Value Weighted 0.0% 0.2% 0.1% 0.0%
Source: MSCI. Average active returns relative to MSCI World from December 1975 to December 2013. Past performance is not a
reliable indicator of future performance.
*Based on official Index Levels from May 1988. Low Volatility Tilt Index prior to that date includes simulated data.
Looking first at the columns for economic growth, results are similar to our
previous analysis, except that Momentum is now ‘cyclical’, with higher active
returns when economic growth is increasing than when it is decreasing.
In the inflation columns, there is no large differentiation between the factor
indices’ responses.
SECTION 2
Classification based on the long-term MSCI Asset Pricing Model

The MSCI Asset Pricing Model follows the basic principle of modern asset
pricing that the competitive equilibrium value of an asset equals the expected
discounted value of current and future asset cash flows. The application of this
fundamental principle of asset valuation leads to the conclusion that macro
risk has an impact on valuation and risk via two channels: cash flows and
discount factors.
Our principal finding is that the cash flows earned by different equity portfolios
can respond differently to persistent economic shocks, and that these
differences can emerge over longer time horizons.
The chart below classifies the MSCI World factor indices according to their
positive or negative sensitivity to real GDP growth and inflation over long
horizons, relative to the MSCI World Index.
EXHIBIT 4: LONG-RUN SENSITIVITIES TO MACROECONOMIC RISK

Real GDP growth risk Outperform when Outperform when
economic growth is strong economic growth is weak
} Equal Weighted } High Dividend Yield
} Momentum } Quality
} Risk Weighted } Minimum Volatility
} Value Weighted
} Small Cap
Inflation risk Outperform when inflation Outperform when inflation

is rising is falling
} Equal Weighted } Minimum Volatility
} Momentum
} High Dividend Yield
} Quality
} Risk Weighted
} Small Cap
Conclusion
The MSCI Asset Pricing Model shows that Equal Weighted, Momentum, Risk
Weighted, Value Weighted and Small Cap indices showed real GDP growth risk
relative to the capitalisation-weighted index in the long run. Thus, in terms of
sensitivity to economic growth, the long-term model-based analysis broadly
agrees with our historical short-term analysis.
Our frameworks and models have important implications for asset allocation
in developed market portfolios (the basis for this analysis), as shown in
Exhibit 4. Deviations away from a market cap portfolio could logically be
based on an investor’s expectations about macroeconomic growth and
tolerance for risk.
SECTION 3: IMPLEMENTING SMART BETA
SECTION 3
Implementing smart beta in portfolios

Smart beta strategies can help achieve a variety of portfolio objectives.
However, implementing smart beta within a traditional asset allocation
framework is often perceived as challenging by investors. Broadly speaking,
smart beta can be used in a portfolio to enhance its risk-return profile, reduce
risk or to diversify along factor dimensions. It is nevertheless important to
consider both investment goals and time horizons.
The implementation of smart beta strategies does not need to be difficult.

There are three key applications to consider: tactical, strategic, and risk
management. The table below outlines potential smart beta applications,
objectives and implementation considerations.
FIGURE 15: APPLICATIONS FOR SMART BETA
Application Tactical Strategic Risk management
Objective Improve Reduce Improve Reduce

Diversify
return risk return risk
Replace and Managing factor

Implementation Implement Get more out
complement exposure/Completion
investment views of beta
active strategies strategies
} Implement tactical } Improve the } Implement a } Complement the

views along factor expected risk- transparent, well- factor exposures of
dimensions adjusted return diversified and the existing manager
} Introduce explicit while retaining the low cost alternative line up and reduce
downside risk transparency and to low-risk active unwanted risks
protection efficiency of beta strategies
Source: BlackRock. September 2015.
INVESTOR INSIGHT:
For us, one of the most exciting things about smart beta is that it is
helping us build the more exact allocation we want. It means you get
better risk-adjusted outcomes and you have fewer surprises in terms
of how your positions perform.
Credit Suisse
[3 6] I M P L E M E N T I N G S M A R T B E TA
SECTION 3
Using smart beta – an outcome-orientated approach

Factors can earn positive returns over the long term as a result of a risk premium,
structural impediment or behavioural anomaly within financial markets. They are
a source of potential incremental returns in long run portfolio allocations. However,
individual factors may be highly cyclical. Although long run returns have historically
been positive, the returns to any single factor may be positive or negative in any
particular month or year. For long-term allocations, diversification across several
factors can help mitigate the potential ups and downs in the short term.
For more tactically-oriented investors, the cyclical nature and distinct

behaviour of individual factors provides a new investment toolkit that may be
used to express investment views. Individual factor strategies are useful as
complements to existing allocations to provide diversification.
How can smart beta fit in a portfolio?

Strategic asset allocation with smart beta
Individual factors have low active correlations with each other, and combining
them can provide more diversified portfolios that perform well in a variety
of market environments. Depending on the risk/return goal, different
combinations may be appealing. For example, as illustrated in the chart below,
equity investors can combine value, minimum volatility, size and other factors
in various proportions to create bespoke portfolios with desirable expected
risk/return profiles.
FIGURE 16: RISK-RETURN PROFILES OF DIFFERENT GLOBAL DEVELOPED

SINGLE EQUITY FACTOR COMBINATIONS
9.5%
Risk & Return Objective Return Objective
MSCI World Enhanced Value
M+V
V+S
MV + V + M
ANNUALISED RETURN
MV + V + S S+ M + V
7.5%
M+S
MV + Q + V + S
MSCI World Mid-Cap Equal Weighted
Q+S+M
MSCI World Momentum
MV + Q + M MV + Q + S
MSCI World Minimum Volatility

5.5%
MV + Q
MSCI World Sector Neutral Quality
MSCI World Index

Risk Objective
3.5%
10% 12% 14% 16% 18% 20%
ANNUALISED STANDARD DEVIATION
MV = Minimum Volatility M = Momentum V = Value Q = Quality S = Size
Source: BlackRock and MSCI as of 30 September 2005 – 30 September 2015. Past performance is not a reliable indicator of
future performance.
SECTION 3
Weighting factors in a portfolio – allocation methodology

Certain investors may have strong convictions about the efficacy and
appropriateness of each factor and those convictions may lead to
bespoke combinations in their portfolios. In the absence of strong views, a
straightforward equal-weighted approach is a reasonable starting point for
long-term, multi-factor allocations.
The table below highlights two portfolio allocations using MSCI World single
factor exposures. The risk parity portfolio weights the exposures such that
the marginal contribution of each of the exposures to the total volatility is
equal. It therefore makes sense that this portfolio has a higher allocation to
World Minimum Volatility and a lower allocation to World Value. In each case
the portfolios are rebalanced annually to static weights and are calculated in
US dollars.
FIGURE 17: EQUAL AND RISK WEIGHTED FACTOR PORTFOLIOS – ALLOCATIONS

World
Allocating factors World World World Minimum World
in a portfolio Value Size Momentum Volatility Quality
Equal weighted 20.00% 20.00% 20.00% 20.00% 20.00%
Risk weighted 16.83% 19.07% 19.31% 26.07% 18.73%
Source: BlackRock. Risk weighted optimisation conducted 30 September 2005 – 30 September 2015.
The allocations between these two portfolios differ by up to 6.07%. However,

the overall difference in terms of performance and risk over the time horizons
is relatively small, as shown in Figure 18.
SECTION 3
FIGURE 18: RISK AND EXCESS RETURN PERFORMANCE OF EQUAL

AND RISK WEIGHTED PORTFOLIOS
Annualised Excess Return to MSCI World Annualised Standard Deviation (Volatility)
4% 18%
3%
12%
2%
6%
1%
0% 0%
1 Yr 3 Yrs 5 Yrs 10 Yrs 1 Yr 3 Yrs 5 Yrs 10 Yrs
World Five Factor Risk Weighted World Five Factor Equal Weighted MSCI World Index
Source: BlackRock, Morningstar, MPI. 30 September 2005 – 30 September 2015.
A simple equal-weighted allocation methodology therefore gives us risk and

return characteristics which are similar to a more complicated allocation
methodology, meaning that the strategic benefits of factor investing can
actually be realised relatively simply.
KEY INSIGHT: Combining factors in a portfolio can

provide improved diversification and performance in
a variety of market environments.
SECTION 3
Implementation case studies

Smart beta can be employed to help meet a variety of objectives. The case
studies below explain how smart beta can help to:
``Build simple outcome-oriented portfolios

`Ìmplement multi-factor exposures in strategic asset allocations
`Èxpress investment views
`Ìmplement tactical factor tilts
`Àddress unintended factor tilts
`Àdd a liquidity sleeve feature to an existing factor allocation
Case Study 1: Building simple outcome-orientated portfolios

In this case study, we have taken the most straightforward approach and have
equally-weighted each of the factor exposures in the portfolio. We consider
three portfolios:
Defensive portfolio: A basket of three factors – minimum volatility,

value and quality – combined in order to minimise risk.
Balanced portfolio: A basket of five factors – size, minimum volatility,

momentum, value, quality.
Dynamic portfolio: A basket of three factors – size, momentum and value –

combined in order to generate extra performance.
[4 0 ] I M P L E M E N T I N G S M A R T B E TA
SECTION 3
The figure below provides more details on the portfolios’ compositions.
FIGURE 19: PORTFOLIO ALLOCATIONS AND FACTOR EXPOSURES

Portfolio 1: Portfolio 2: Portfolio 3:
Defensive Factor Portfolio Balanced Factor Portfolio Dynamic Factor Portfolio
Growth Growth Growth

Volatility Financial Volatility Financial Volatility Financial
Leverage Leverage Leverage
Value Liquidity Value Liquidity Value Liquidity
Size Momentum Size Momentum Size Momentum

Nonlinearity Nonlinearity Nonlinearity
Size Size Size
MSCI World Defensive Factor Portfolio Balanced Factor Portfolio Dynamic Factor Portfolio
Factor Exposure Weight Factor Exposure Weight Factor Exposure Weight
World Minimum 33% World Size Factor 20% World Size Factor 33%
Volatility Factor
World Value Factor 33% World Minimum 20% World Momentum 33%
Volatility Factor Factor
World Quality Factor 33% World Momentum 20% World Value Factor 33%
Factor
World Value Factor 20%
World Quality Factor 20%
Source: BlackRock and MSCI. 30 September 2015.
Portfolio 1 (Defensive Factor Portfolio) uses defensive factor exposures, such

as minimum volatility and quality alongside a diversifying factor such as value,
with the aim to provide broad market exposures but with a lower volatility than
the benchmark MSCI World Index.
Portfolio 2 (Balanced Factor Portfolio) takes a neutral view in that multiple

single factor exposures are used in equal weight to achieve diversified
exposure across many factors.
Portfolio 3 (Dynamic Factor Portfolio) is at the other end of the spectrum.

By including pro-cyclical factors that have historically outperformed the
MSCI World Index more significantly, but with a higher volatility, the aim
is to create a more aggressive equity portfolio which has the objective of
outperforming the MSCI World Index. Portfolio 3 carries more risk. This means
that in implementing this strategy, the investor would need to be comfortable
taking more risk in order to achieve the outperformance objective.
S M A R T B E T A G U I D E [ 41 ]
SECTION 3
The resulting risk and return profiles of the portfolios over a ten-year
period are shown in Figure 20 and behave in line with the initial objectives.
Defensive Portfolio 1 enhances the return slightly versus the benchmark
but allows risk to be reduced on a rolling basis. Balanced Portfolio 2 takes
on a little more risk but performs better than Portfolio 1 on a cumulative
basis. Dynamic Portfolio 3, as was aimed for, achieves the strongest
outperformance but at times has a higher annualised volatility compared
to the benchmark.
FIGURE 20: PERFORMANCE AND RISK OF THE DYNAMIC, BALANCED AND

DEFENSIVE PORTFOLIOS
300
CUMULATIVE PERFORMANCE
250
200
150
100
50
Oct 04 Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10 Oct 11 Oct 12 Oct 13 Oct 14 Oct 15
MSCI World Defensive Factor Portfolio MSCI World Balanced Factor Portfolio
MSCI World Index MSCI World Dynamic Factor Portfolio
40%
12 MONTH ROLLING VOLATILITY
30%
20%
10%
0%
Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10 Oct 11 Oct 12 Oct 13 Oct 14 Oct 15
MSCI World Defensive Factor Portfolio MSCI World Balanced Factor Portfolio
MSCI World Index MSCI World Dynamic Factor Portfolio
Source: BlackRock, Markov Processes International (MPI), Morningstar, MSCI, Bloomberg. 5 January 2005 – 5 October 2015.
Frequency: Day. USD. Past performance is not a reliable indicator of future performance.
SECTION 3
The flexibility of using single factor exposures to create outcome-orientated

combinations is clear from this example. A key feature of such exposures –
with geographical and sector diversification being in line with the benchmark
– allows for such portfolios to be integrated effectively within asset allocations
without drastically changing any tactical over/underweights within the
portfolio (Figure 21). This is, of course, a separate and important consideration,
and the overall results should be considered and analysed to ensure overall
allocations are within tolerance levels.
FIGURE 21: REGIONAL AND SECTOR EXPOSURES OF THE BALANCED,

DEFENSIVE AND DYNAMIC FACTOR PORTFOLIOS
Regional exposure Sector exposure
Consumer
North Discretionary
America Consumer
Staples
Energy
Europe
Financials
Pacific Health Care

ex Japan Industrials
Information
Technology
Japan
Materials
Telecom
Services
Israel
Utilities
0% 20% 40% 60% 80% 0% 5% 10% 15% 20% 25%
MSCI World Balanced Factor Portfolio Dynamic Factor Portfolio Defensive Factor Portfolio
Source: BlackRock, MSCI. Data as of end of September 2015.
SECTION 3
Case Study 2: Implementing multi-factor exposures in strategic

asset allocations
For investors seeking a ‘turnkey’ smart beta solution, multi-factor indices
provide an easy complement to traditional passive or active strategies. For
example, they can combine quality, value, size and momentum to deliver an
enhanced return relative to the broad market at a similar level of risk. They can
be used within a portfolio to enhance the overall risk return characteristics
without the need to make decisions on which factors to use, when to use them
and how to combine them.
A multi-factor exposure, such as the MSCI World Diversified Multiple Factor

Index, can be used in conjunction with, or in lieu of, broad market capitalisation
exposures to enhance returns. Figure 22 demonstrates this effectively by
looking at a simple diversified global multi-asset portfolio and integrating
multi-factor exposure by replacing the global equity allocation. Annualised
return over the 10-year period analysed increases from 4.75% to 6.19% and
risk-adjusted return from 0.43 to 0.56.
FIGURE 22: ASSET ALLOCATIONS WITH AND WITHOUT THE MSCI WORLD
DIVERSIFIED MULTIPLE FACTOR INDEX
Sample: No Smart Beta Indices Sample: With Diversified Multiple Factor Index
Barclays Global Aggregate Index 40.0% Barclays Global Aggregate Index 40.0%
MSCI Emerging Markets Index 5.0% MSCI Emerging Markets Index 5.0%
MSCI World Index 55.0% MSCI World Diversified Multiple-Factor Index 55.0%
Sample portfolio Sample portfolio
No smart beta With multiple

indices factor index
Annualised return (10-year) 4.75% 6.19%
Annualised standard deviation (10-year) 11.12% 11.16%
Risk-adjusted return 0.43 0.56
Max drawdown* -36.40% -35.49%
Max drawdown period 11/2007 – 2/2009 11/2007 – 2/2009
Source: BlackRock, MPI. 30 September 2005 - 30 September 2015. Analysis assumes quarterly rebalancing.
Sample portfolios are for illustrative purposes only, and do not represent a recommendation of any security or asset.
* Max drawdown is the peak-to-trough decline during a specific record period of an investment.
SECTION 3
If portfolio risk is a particular concern/objective for implementing smart beta

strategies, multi-factor strategies can be used in conjunction with single
factors, such as minimum volatility. Using minimum volatility strategies to
reduce the overall portfolio volatility can be an effective tool in managing
overall risk, though returns may be reduced in certain market conditions in
order to achieve this. Such an implementation strategy is demonstrated in the
example in Figure 23.
FIGURE 23: USING MINIMUM VOLATILITY EXPOSURES ALONGSIDE

A MULTI-FACTOR APPROACH
Sample: No Smart Beta Indices Sample: With Diversified Multiple-Factor
and Minimum Volatility Indices
Barclays Global Aggregate Index 40.0% Barclays Global Aggregate Index 40.0%
MSCI Emerging Markets Index 5.0% MSCI Emerging Markets Index 5.0%
MSCI World Index 55.0% MSCI World Diversified Multiple-Factor Index 35.0%
MSCI World Minimum Volatility Index 20.0%
Sample portfolio Sample portfolio
No smart beta With multiple

indices factor index
Annualised return (10-year) 4.75% 6.07%
Annualised standard deviation (10-year) 11.12% 9.94%
Risk-adjusted return 0.43 0.61
Max drawdown return* -36.40% -32.52%
Max drawdown period 11/2007 – 2/2009 11/2007 – 2/2009
Source: BlackRock, MPI. 30 September 2005 – 30 September 2015. Analysis assumes quarterly rebalancing. Sample
portfolios are for illustrative purposes only, and do not represent a recommendation of any security or asset.
* Max drawdown is the peak-to-trough decline during a specific record period of an investment.
SECTION 3
Case Study 3: Targeted smart beta strategies to express

investment views
INVESTOR
Individual factors are driven by different market phenomena and, therefore,
INSIGHT:
tend to have distinct behaviours in reaction to market events and the global
Each risk
business cycle. Investors have long connected the performance of equity
premium has its
sectors to the business cycle: Consumer cyclicals tend to perform well when
cycle, meaning we
economic growth is strong, for example, while more defensive sectors such
have to balance as utilities often rally in risk-averse environments when investors are seeking
the factors. safety. The same parallel can be seen in the behaviour of factors. Smaller,
Asian Sovereign more nimble companies (emphasised in small size strategies) often perform
Wealth Fund well in the early phases of economic recovery. In contrast, stable companies
with strong balance sheets (emphasised in quality strategies) tend to perform
best in later stages of the economic cycle. Single factor smart beta strategies
provide a useful toolkit for investors to express their investment views.
FIGURE 24: MAPPING FACTOR EXPOSURES TO THE ECONOMIC CYCLE

High quality Value Positive momentum Low size
High earnings Inexpensive Companies on Companies with

quality companies an upswing illiquidity premiums
EARLY CYCLE MID CYCLE LATE CYCLE CONTRACTION

RECOVERY SLOWDOWN PICK-UP
MOMENTUM QUALITY
VALUE
Typical behaviour QUALITY
of global
business cycle MOMENTUM
SIZE
VALUE
MOMENTUM

Sources: BlackRock, Global Return Premiums on Earnings Quality, Value, and Size, 7 January 2013, Max Kozlov and
Antti Petajisto. The opinions expressed are as of 31 March 2015 and are subject to change at any time due to changes
in market or economic conditions.
SECTION 3
Case Study 4: Implementing tactical factor tilts

Targeted smart beta strategies, such as single factor funds, may be used
tactically to seek increased returns or reduced risk in accordance with an
investor’s current market view.
In this case study, we have created three separate portfolios, compared to a

standard MSCI World Index.
Portfolio 1: Adding a size tilt (10%) to emphasise the nimble companies that
often perform well in the early stages of the business cycle.
Portfolio 2: Add a minimum volatility tilt (10%) in order to alter the portfolio’s
risk profile in anticipation of increased market volatility.
Portfolio 3: Add both size and minimum volatility tilts (20%) to seek to improve
returns while managing the total level of equity risk.
The results from this implementation can be seen in Figures 25 and 26.
The factor allocation between volatility and size is easily discernible from the
graphs in Figure 25, while the achieved outcome of single factor exposures is
highlighted in Figure 26.
FIGURE 25: FACTOR TILTED PORTFOLIOS AND THEIR FACTOR EXPOSURES

Portfolio 1: Introduce Portfolio 2: Introduce 10% Portfolio 3: Introduce both 10%
10% size tilt to enhance minimum volatility tilt to limit size and 10% minimum volatility
performance the downside tilts to address both goals
10% 10% 10%

10%
90% 90% 80%
World World Size World Volatility
Growth Growth Growth

Volatility Financial Volatility Financial Volatility Financial
Leverage Leverage Leverage
Value Liquidity Value Liquidity Value Liquidity
Size Momentum Size Momentum Size Momentum

Nonlinearity Nonlinearity Nonlinearity
Size Size Size
MSCI World MSCI World - Size tilt MSCI World - Min Vol tilt MSCI World - Size and Min Vol tilt
Source: BlackRock, MSCI, data as of September 2015.
SECTION 3
FIGURE 26: EXCESS RETURN PERFORMANCE OF FACTOR-TILTED PORTFOLIOS
6
CUMULATIVE EXCESS RETURN
VS MSCI WORLD INDEX
-2
Sep 04 Sep 05 Sep 06 Sep 07 Sep 08 Sep 09 Sep 10 Sep 11 Sep 12 Sep 13 Sep 14 Sep 15
Portfolio 1: Size tilt Portfolio 2: Min Vol tilt Portfolio 3: Size and Vol tilt
Source: BlackRock, MPI, Morningstar, MSCI, Bloomberg. 31 March 2004 – 30 September 2015. Frequency: Month. USD. Past
performance is not a reliable indicator of future performance.
Risk management and portfolio analysis across factor dimensions

Multi-manager portfolios often result in overlapping exposures and unintended
bets. The stock selection process of a successful active manager may result
in unintended style biases while multiple managers may layer on similar
exposures. Analysing portfolios along style dimensions allows investors to
understand and control these risks. Regional factor ETFs can further assist in
this process and provide tools for managing regional factor biases (Figures 27
and 28).
SECTION 3
Case Study 5: Analysis of portfolio risk factors to address

unintended factor tilts
For bottom-up global portfolios, the resulting basket may sometimes have
an unintended factor tilt. Factor ETFs can be used to manage this tilt and to
neutralise unintended factor exposures within the portfolio. The target portfolio
(Portfolio 1) has an exposure to a variety of global developed market companies
with a geographical tilt towards Japan. After factor analysis was carried out,
an unintended bias towards stocks with higher volatility was identified.
Using factor ETFs with exposure to low volatility stocks allowed us to neutralise
the unintended factor tilt (shown in Portfolio 2) and to keep the factor profile
of the portfolio in line with the MSCI World Index. From a diversification
perspective, Portfolio 2 broadly maintained the desired overweight to Japanese
equities but achieved a sector and regional profile which was closer to that of
the MSCI World Index.
FIGURE 27 AND 28: USING SINGLE FACTOR EXPOSURES TO ADDRESS

UNINTENDED FACTOR TILTS IN A PORTFOLIO
Portfolio 1: Global equity portfolio with 20% Portfolio 2: Global equity portfolio with 20% Japan
Japan overweight vs MSCI World overweight – Volatility bias corrected
15.00% 16.78%
19.74%
28.60%
24.31%
3.25%
2.63% 38.91%
45.78%
2.76%
2.24%
MSCI Europe MSCI USA MSCI Canada

MSCI Pacific ex Japan MSCI Japan MSCI World Minimum Volatility Index
Growth Growth
Volatility Financial Volatility Financial
Leverage Leverage
Value Liquidity Value Liquidity
Size Momentum Size Momentum

Nonlinearity Nonlinearity
Size Size
MSCI World Portfolio 1 Portfolio 2
Source: BlackRock, MSCI, data as of September 2015. This is not a recommendation to invest in any particular financial
product. No analysis of their suitability was conducted and no statement of opinion in relation to their suitability is provided.
SECTION 3
Case Study 6: Adding a liquidity feature to your existing

factor allocation
Factor ETFs can be used as a liquidity ‘sleeve’ solution for core, non-ETF factor
allocation. Many large institutional investors have historically used customised
factor mandates to achieve a desired long-term factor(s) exposure. To ensure
the factor(s)’ weight is in line with the overall strategy, factor ETFs can provide
a cost-efficient and flexible liquidity ‘sleeve’ solution in order to manage the
deviation from the original weights within the portfolio which occur over time.
The current portfolio is allocated across three vehicles where two have a global
equity factor exposure – an active momentum manager and a global value
factor fund. The third one is a low-cost global equity indexed mandate.
Using factor ETFs enables investors to build the liquidity sleeve around the two
factor-based core allocations and the traditional mandate while minimising
transaction costs during rebalancing.
FIGURE 29: USING SMART BETA ETFs WITHIN AN ASSET ALLOCATION

AS A LIQUIDITY SLEEVE
Original Portfolio Portfolio with an ETF Overlay
World M
% om
en
y3 tu
rla m
ve
Global Global
ET
FO
3% World
FO
Active Active
ET
Value
verl
Global Value Momentum Global Value Momentum
World Value
Factor Fund 25% Factor Fund 23%
ay 2%
Fund 35% 2% World Fund 32%
+ Momentum =
Global 5% World Global

Equity Index Equity Index
Fund 40% Fund 35%
%
y5
rla
W o rld E T F O ve

Source: BlackRock, MSCI, data as of September 2015.
[ 5 0 ] I M P L E M E N T I N G S M A R T B E TA
SECTION 3
INVESTOR CASE STUDY: The unemotional reliability of smart beta –

CLS Investments, LLC
CLS Investments (CLS), a third party investment manager and ETF Strategist,
uses risk-managed, globally balanced portfolios to enhance the investor
experience. A firm believer in the power of risk budgeting delivered through
outcome-based investment options, CLS manages risk and investments for
those seeking to accumulate wealth, generate income, protect their assets
or manage tax within their portfolios.
Today, CLS manages nearly US$ 6BN for more than 35,000 investors.
Why invest in smart beta?

CLS believes that smart beta provides a performance edge and a better
mechanism to manage risk. Smart beta portfolios are based on factor
investing, such as value, momentum, etc., which some CLS portfolio managers
have been researching as far back as the 1990s.
Prior to CLS’s commitment to ETFs (pre-2001), CLS portfolio managers were

generally constrained to a style box approach, which limited investments to
active mutual funds. The lack of transparency and style drift from these funds
required CLS to perform detailed due diligence on a more regular basis. ETFs,
and particularly smart beta ETFs, provide CLS with precision tools to articulate
its market views and achieve a set outcome more efficiently. The rules-based
construction of smart beta also ensures CLS’s portfolio managers remain
disciplined and not vulnerable to emotion. Overall, CLS views smart beta as a
way to access the essence of active management at a fraction of the cost.
How to invest in smart beta?

CLS performs factor-based analyses and risk budgeting to enhance risk
management. Portfolio managers start with a strategic risk allocation and
execute a flexible asset allocation approach to respond to changing risk levels
in the market. CLS has recently invested in additional tools to actively assess
various factors, including their expected returns and risk characteristics.
Portfolio managers evaluate the strategies daily, though the typical holding
period is still around two to three years with turnover ranging between 30-50%.
When it comes to specific factor evaluation, CLS monitors relative valuations,
relative momentum and other variables prior to implementation. While the
magnitude of smart beta inclusion in portfolios can vary, more strategies are
becoming explicitly tied to a factor-based approach.
CLS manages thousands of portfolios, and many have dramatically increased

exposure to smart beta since the availability of ETF products and dedicated
risk-based evaluations. Its average portfolio has approximately one-third
allocated to smart beta, and CLS expects that number to rise.
S M A R T B E TA G U I D E [ 51]
SECTION 3
The portfolio and comments below provide a snapshot of the evolution

of smart beta implementation within one of many CLS portfolios. This is a
global equity portfolio that employs an ‘aggressive’ strategy that spans all
market capitalisations.
FIGURE 30: USAGE OF SMART BETA ETFs: MARCH 2012 VS MARCH 2015
Holdings as of 31 March 2012 Holdings as of 31 March 2015
Market cap 86% Market cap 54%

Smart beta 12% Smart beta 46%
``CLS’s smart beta ETF usage has nearly quadrupled since 2012 (as a percentage of holdings).
``Historically, CLS’s usage of smart beta ETFs consisted mainly of dividend-focused funds and
revenue-weighted products.
``CLS’s current smart beta usage expands to factors, equal weighting, dividend weighting, etc.
as ETFs that focus on exposure to individual factors become available.
Source: CLS Investments.
KEY INSIGHT: Smart beta strategies can be used in

portfolios to implement investment views, get more out
of beta, replace and/or complement active strategies
or manage factor exposure.
[ 5 2] I M P L E M E N T I N G S M A R T B E TA
SECTION 3
Smart beta beyond equities

The focus on smart beta strategies over the past few years has spurred
research and the design of products that seek to improve results in a
transparent and rules-based strategy. Most product development and client
implementation has been in long only equities, but one can apply this approach
to other asset classes as well. While it is likely that equity-based smart beta
will continue to grow and advance, other asset classes, including fixed income
and commodities, present opportunities for innovation too.
Fixed income smart beta

Throughout the three-decade bull market in bonds, cap-weighted fixed income
indices have generally delivered high risk-adjusted returns and provided an
important counterbalance to equity market risk. As the bull market appears
to be coming to an end, investors are increasingly concerned about managing
exposures to the common risk factors that drive returns for bond portfolios.
The risk and return of broad fixed income indices can be largely explained by
two risk factors: interest rate risk and credit risk. In addition, there are market-
structure phenomena in fixed income that create potential opportunities; bond
market investors often have set preferences regarding credit quality and term
structure, resulting in a segmented market.
Building upon this understanding of the nature of risk and return in fixed
income markets, this section examines how investors may be able to use
smart beta techniques to construct more efficient alternatives. The various
construction techniques can be grouped into three specific outcomes:
``better diversification
`ìmproved risk-return profiles
``precision exposure to specific factors or market anomalies
S M A R T B E TA G U I D E [ 5 3]
SECTION 3
As an illustration, the following demonstrates a way to diversify macro risk

factor exposure. Historically, within broad-based indices such as the Barclays
US Aggregate Index, interest rate risk has been the dominant factor by a wide
margin, while credit spreads have contributed relatively little in terms of either
risk or return. (See the left-hand bars of the two charts in Figure 31).
FIGURE 31: RISK AND RETURN OF BARCLAYS US AGGREGATE INDEX VS

HYPOTHETICAL RISK-BALANCED STRATEGY
Risk contribution over the last 5 years Return contribution over the last 5 years
3.5% 30%
3.0%
25%
2.5%
20%
2.0%
1.5% 15%
1.0%
10%
0.5%
5%
0.0%
-0.5% 0%
Barclays US Risk Balanced Barclays US Risk Balanced
Aggregate Index Strategy Aggregate Index Strategy
Rates contribution Spread contribution Rates contribution Spread contribution
Source: Barclays and BlackRock. Charts based on the monthly returns of the Barclays US Aggregate Index and the
‘risk balanced strategy’ from January 2010 to March 2015. Past performance is not a reliable indicator of future performance.
Left chart: the risk is measured by 24 realised volatility (annualised) averaged over the last five years.
Index performance is shown for illustrative purposes only. One cannot invest directly in an index.
One approach to increase diversification would be to balance credit and interest

rate risk. This can be achieved by re-weighting the underlying components of
the Barclays US Aggregate Index. To test the effectiveness of this approach,
we decompose the risk and return of the hypothetical risk-balanced strategy
by identifying the contribution coming from interest rate exposure and the
contribution coming from credit spread exposure. (See the right-hand bars of the
two charts in Figure 31). In Figure 32 we provide the performance comparison of
the risk-balanced strategy to the Barclays US Aggregate Index. The returns are
very similar, but with less volatility and a higher yield to maturity.
SECTION 3
FIGURE 32: PERFORMANCE COMPARISON BETWEEN

BARCLAYS US AGGREGATE INDEX AND HYPOTHETICAL
RISK-BALANCED STRATEGY
Return over Yield to
Return Volatility volatility maturity
Barclays US
6.0% 3.6% 1.7 2.1%
Aggregate Index
Risk Balanced Strategy 5.8% 2.6% 2.2 2.8%
Source: BlackRock and Barclays. Figures calculated over the period from December 1991 to
March 2015. Returns and volatility are annualised. Yield to maturity is as of March 2015. Index
performance is shown for illustrative purposes only. One cannot invest directly in an index.
Given the current macroeconomic environment, and the prospect for an

extended period of rising interest rates, many investors are seeking more
diversified and factor-aware approaches to fixed income investing. While smart
beta represents a relatively new approach to fixed income investing, this area
of research may help investors address many of their most pressing needs.
Commodities
Commodities offer diversification benefits as well as some inflation protection.
Commodity exposure is mainly achieved through rolling positions on futures
contracts because of various complications of trading them physically. This
investment approach has an impact on the total return of the position, which
can be broken down into three components:
Roll return
+ +
Spot return Return associated with Collateral return
Change in the spot the process of moving Return obtained
price of the underlying (rolling) between one through the purchase of
commodity futures contract as it a risk-free investment
matures to the next
These are important aspects that should feed into index construction along
with various other considerations such as:
``which commodities to include

``weighting methodology
``maturity and contract schedule
S M A R T B E TA G U I D E [ 5 5 ]
SECTION 3
The first generation of commodity indices, such as S&P GSCI, as well as the
Bloomberg Commodity Index allocate to a broad set of commodities and
consider characteristics such as quantity of production as well as liquidity
of contracts for selection and weighting. While this approach provides broad
exposure to the commodities market, it leaves investors vulnerable to certain
important features such as negative roll yield because of the persistent
headwind that results from rolling future contracts. Second generation indices
include specific features that reduce the impact of negative roll yield, look
to capture wider futures curve exposure via investments across multiple
maturities, use modified rolling windows and modified contract schedules
as well as capture seasonality effects (certain commodities exhibit strong
seasonality due to supply and demand dynamics).
FIGURE 33: PERFORMANCE ANALYSIS OF COMMODITY INDICES
1200
INDEX LEVELS (REBASED TO 100)
1000
800
600
400
200
0
Jan 93 Jul 95 Jan 98 Jul 00 Jan 03 Jul 05 Jan 08 Jul 10 Jan 13 Jul 15
Bloomberg Roll Select Commodity Bloomberg Commodity Index
Bloomberg Roll Select Commodity Bloomberg Commodity Index
Return 6.49% 2.75%
Volatility 13.95% 14.91%
Return over volatility 0.47 0.18
Max drawdown* -51.93% -60.19%
Source: Bloomberg. Data as of 31 January 1991 to 31 July 2015. Past performance is not a reliable indicator of future performance.
* Max drawdown is the peak-to-trough decline during a specific period of an investment.
Figure 33 shows an example of a first and second generation commodity index,

the Bloomberg Commodity Index and the Bloomberg Roll Select respectively.
The risk and return profile of the Roll Select strategy has been superior over
the time period considered. This has been achieved by adding a rule in the
methodology that considers the roll yield of contracts that are further out on
the futures curve and selects the highest yielding one.
SECTION 3
As with other asset classes, in commodities it is important to understand the

drivers of risk and return. We have highlighted some of the important factors
such as roll return, liquidity, and seasonality. More advanced factor strategies
may employ a long/short approach to hedge certain risks and capture desired
factors in a more targeted manner.
Smart beta research will continue to develop, seeking more dynamic ways to
isolate risk factors. While equity smart beta currently captures the majority
of assets, smart beta across other asset classes may prove the most ground-
breaking developments in years to come.
KEY INSIGHT: Factor investing is not confined to

equity factors. Smart beta strategies are being developed
across asset classes.
S M A R T B E TA G U I D E [ 5 7 ]
SECTION 3
“Understanding a portfolio’s drivers

of risk and return allows investors
to be more informed and to develop
more optimal portfolios to seek higher
returns. Initially, factor investing was
a tool for institutional investors with
access to sophisticated investment
models. Smart beta strategies now
make this investment style affordable
and accessible to every investor.”
Andrew Ang, PhD
Head of BlackRock’s Factor Based Strategies Group
S M A R T B E TA G U I D E [ 5 9]
Acknowledgements
BlackRock would like to thank those who have generously shared their insights
for this guide:
MSCI Inc.
MSCI Inc. is a leading provider of investment decision support tools to investors
globally, including asset managers, banks, hedge funds and pension funds.
MSCI products and services include indices, portfolio risk and performance
analytics, and ESG data and research. MSCI is headquartered in New York,
with research and commercial offices around the world.
Asian Sovereign Wealth Fund

An Asian sovereign wealth fund with a mandate to manage assets entrusted by
its government and central bank.
CLS Investments, LLC

CLS Investments (CLS), a third party investment manager and ETF Strategist,
uses risk-managed, globally balanced portfolios to enhance the investor
experience. A firm believer in the power of risk budgeting delivered through
outcome-based investment options, CLS manages risk and investments for
those seeking to accumulate wealth, generate income, protect their assets,
or manage tax within their portfolios. Today, CLS manages nearly US$6BN for
more than 35,000 investors.
Credit Suisse
Credit Suisse Multi Asset Class Solutions (MACS) develops and implements
investment allocation strategies across asset classes for both private
and institutional clients. Credit Suisse’s solutions can combine traditional
investments, such as cash, bonds and equities, with non-traditional alternative
investments to meet clients’ needs. The product range includes funds and
certificates to discretionary mandates, covering retail clients to ultra-high
net worth individuals.
``Manages about CHF105.6BN in assets (as of 30 April 2014)

`Èmploys more than 300 investment specialists
``Maintains a global network with local specialists in Europe, Asia
and the Middle East
`Òffers a wide range of investment solutions for private and institutional clients
[60] ACKNOWLEDGEMENTS
Dutch Private Bank
A modern Dutch Private Bank, internationally present and locally involved with
a leading position in Europe and a solid presence in Asia.
Providing a full range of banking, financial & estate planning, investment

services and products, the Private Bank is backed by the strength of a global
banking group, servicing more than 100,000 clients through 53 domestic and
international branches in 10 markets worldwide. Their clients have entrusted
€209BN in assets to them.
EXS Capital Group

The EXS Capital Group (EXS) is an independent investment firm dedicated to
Asia Pacific. EXS specialises in sophisticated wealth management for high
net worth expatriates and Asian families. EXS’ clients include successful
professionals, investors and entrepreneurs in Asia, typically with a net worth
of US$2MN and above.
EXS provides a comprehensive suite of services, including asset management,

estate planning, insurance, personal financial planning, property investments
and tax structuring.
S M A R T B E TA G U I D E
SECTION 1
Want to know more?

+44 (0) 845 740 5405 [email protected] blackrock.com
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Blackrock Smart Beta Guide en Au PDF

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What is the main topic discussed in the document?

What is the main topic discussed in the document?

What is the author's perspective on factor investing?

What is the author's perspective on factor investing?

FOR PROFESSIONAL CLIENTS/QUALIFIED

INVESTORS/SOPHISTICATED INVESTORS ONLY

Andrew Ang, PhD

Factor investing is a framework that can produce superior diversification, return

Factor investing captures these drivers of returns, taking advantage of investment

SECTION 1: UNDERSTANDING SMART BETA 6

Why investors should explore smart beta 10

The rationale for factor-based investing 13

Factor index construction essentials – MSCI 16

Smart beta in numbers 20

SECTION 2: ASSESSING SMART BETA 22

Smart beta attribution and challenges 26

Factor behaviour in changing economic environments – MSCI 31

SECTION 3: IMPLEMENTING SMART BETA 34

Investor case study – CLS Investments, LLC 51

Smart beta beyond equities 53

Defining smart beta

An overview of smart beta’s history

Factor investing seeks to identify and capture broad, persistent drivers of

The objectives of smart beta

FIGURE 1: WHAT SMART BETA IS AND WHAT IT IS NOT

What smart beta is What smart beta is not

Objective rules Proprietary

High capacity Nuanced

Active, passive or something in between

Cap-weighted Smart Actively

Potential for Moderate

Turnover and Moderate

Liquidity and Low to

Transparency High High Low

KEY INSIGHT: Smart beta strategies aim to capture drivers

Why investors should explore smart beta

``Improved portfolio outcomes

Improved portfolio outcomes

FIGURE 3: RISK AND RETURN OF MSCI FACTOR INDICES

High Dividend Yield

An individual investment strategy or product may appear attractive in isolation

Access to minimum volatility equity, multi-factor equity and balanced risk

FIGURE 4: THREE PORTFOLIOS FOR US EQUITIES AND

60% MSCI USA

Max drawdown* -31.29% -26.46% -33.52%

FIGURE 5: PORTFOLIO PERFORMANCE COMPARISON

Reduction of portfolio cost

KEY INSIGHT: Smart beta allows investors to:

The rationale for factor-based investing

Understanding drivers of risk and return

Finding the right mix of assets requires an understanding of the economics

FIGURE 6: FACTOR EXPOSURE MATTERS

Domestic Equity Real Estate

Factors are the fundamental

For illustrative purposes only.

Behavioural, risk and structural factor categories

``Behavioural biases – the psychological aspect of investment decisions

FIGURE 7: SOURCES OF PORTFOLIO RISK AND RETURN

Macro risk factors

45 % of the ~800 smart beta ETPs globally