This article is targeted towards actuaries and risk managers working at insurance companies. This article must not be construed by consumers as investment advice or product recommendation.
Smart Beta
As the name suggests, the beta needs to be smart (not high). Beta, here, measures the sensitivity of the index return to the return of the overall stock market (which can be represented by the S&P 500 index). For instance, a Beta of 2 means that if the overall stock market goes up by 1%, then the (smart beta) index goes up by 2%. Ideally, we want the index to give positive returns despite its low beta. In other words, we want the beta to be small and smart. High beta will result in high correlation with the overall market, defeating the purpose of the index.
So, in the simplest sense, we need our ideal smart beta index to have two main qualities:
1. Diversification
Low beta (e.g., between 0 and 0.5), relative to the overall stock market, would suggest that including this index in a portfolio will provide a diversification benefit to the overall portfolio. In specific terms, a retiree has ample opportunities to gain exposure to market-capitalization weighted indices (such as S&P 500). And so, she wants to diversify away from market-cap weighted indices, but not away from equities. Hence they do not want negative beta.
2. High-quality (smart) exposure to equities
Investors have numerous definitions for high-quality businesses, depending on their various investment thesis. Some investors may have the traditional preference for value stocks (low price-to-book ratio and high earnings yield). Other investors may have a preference for high growth rate of revenue or customer base, irrespective of profitability. For instance, we prefer to pick from highly liquid stocks that have consistently positive earnings and low dividend yields.
Low dividend yield
Policyholders want the stock price (making the index) to go up. If the stocks have high dividend yield, the business profits will just come out of those stocks via dividends. Policyholders want the profits to stay inside the stocks.
Individual Stock Volatility vs Liquidity
Individual stocks may show high volatility. But when dozens of high-quality stocks are put together in an index, the overall volatility of the portfolio (index) may become low enough. Hence we do not necessarily prefer low volatility stocks. We do, however, prefer to pick from among the most liquid stocks since the cost of hedging will go up dramatically with increasing illiquidity of the stocks that constitute the index.
Putting it together
Eventually, designers of smart beta indices need to decide how to use these two dimensions (diversification and high-quality). A simple 50%-50% weightage given to these two dimensions can be a good starting point.
Bonus Section
What should be inside the index?
Preferably only stocks and cash, and money market instruments (when there is enough cash).
Well, one easy way of having low correlation with the broad stock market is to have no stocks at all in your index. That would be dumb beta, the antithesis of smart beta.
Commodities such as oil and grains either just eat up resources via storage costs, or just rot. Commodities, unlike businesses, do not make money. Moreover, retirees have no interest in speculating on the short-term price of commodities. Policyholders want to indirectly buy businesses by buying indexed annuities. If they want more interest rate exposure, they can just increase the allocation to the fixed rate inside their annuity, which is always an option open to them.
What would an ideal index look like on a chart?
If the index chart shows a slow and steady climb up with an annual return of prime rate + 1%, then that would be a phenomenal outcome for policyholders. By slow we mean low volatility, so the index will have a lower cost of hedging. The higher the index volatility, the higher will be the cost of the hedging, and lower will be the cap (maximum upside) on policyholder returns. For instance, for an indexed annuity investor, a meagre 6% return for 5 years will compound to a cumulative total return of 34%, while a tumultuous set of returns of [20%, -10%, -10%, 20%, 15%] capped at 6% will compound to only 19%. A stock market investor will earn the same return in both cases (assuming he has the stomach to see it through).
Is market capitalization weighing any good?
Yes, absolutely. Theoretically, market capitalization weighing is the most rational (and mathematically sound) way of allocating portfolio weights to stocks. However, given the stock market in its current state in the developed markets, other methods such as efficient frontier (high-return-and-low-variance) or some other ‘risk-adjusted-return’ formula might also work for investors. Clearly, equal weightage is not a rational method because it will require that you invest the same amount of dollars (capital) into a penny stock as that into a large cap stock.
Do policyholders need exposure to commodities as a hedge against inflation?
No. Although commodities such as grains, oil, and precious metals are (very) poorly correlated to inflation, they may still provide a limited hedge against rampant inflation. But, in conditions of low or reasonable (1%-6%) inflation, nominal rates will be high to provide sufficient protection from inflation to a retiree. Real estate (house rent) is often the biggest component of the cost of living, but even real estate prices remain overwhelmed by demand-supply and wealth effects. Moreover, it is important to keep in mind that stocks do not perform poorly in low or reasonable inflation.
High transparency is better
We advise insurers to stay clear of secret magic ‘discretionary’ formulas of stock picking. Transparent, systematic formulas ensure that the stocks that are picked for inclusion in the index are not chosen because someone (perhaps a wealthy client of the investment bank) wants to sell them.
Avoid Excess Return
An excess return is calculated by subtracting a benchmark rate (e.g., a short-term interest rate such as SOFR or Libor) from an original (parent) index. So, if the parent index gained 8% year-over-year, and the annualized short-term rate was 5%, the excess return is only 3%. Having an annuity indexed to an excess return index can make sense for the policyholders when both inflation and nominal rates are very low, and stock volatility is very high. Since an excess return index has a significant chunk of return already taken out of it, it has a low likelihood of going up enough, and so the cost of hedging an excess return index is much lower than the cost of hedging the original index. A cheaper hedge (cheaper option) for an excess return index may sometimes (improperly) incentivize an insurer to increase the participation rate. But a lot of nothing will still be nothing.
Excess Return = Total Earnings - Dividends - Interest Rate
Total Return is better than Price Return
As a business earns money, it either accumulates inside the business (via surplus or reinvestments), or gets paid out to shareholders via dividends. The total return of a business is the sum total of all earnings of the business, including dividends. When dividends do get paid out, the price of the stock goes down, because, after all, money has come out from the business and into the hands of shareholders. The price return reflects this (now) lower price of the stock (business), which is calculated after subtracting the dividends paid out. So, an annuity linked to a total return index will be more valuable for the policyholders than an annuity linked to a price return index, since for a collection of dividend-paying businesses, the total return will be higher than the price return.
Total Return > Price Return > Excess Return
Target Volatility
Volatility is a key driver of hedging costs. Index managers prefer to keep the volatility of the index near a (low) targeted level, which can be anywhere from 5% to 12%. To achieve this, they continuously adjust the allocation of invested capital between stocks and cash. Cash has zero volatility. So, the higher the allocation to cash, the lower will be the volatility of the overall index (stocks + cash combined). Most indices covert cash into money-market instruments when there is sufficient cash allocation in the volatility-controlled index.
At Annuity Risk, we help insurers pick the right smart beta indices from an ocean of available options. We also assist insurers and their banking partners in developing highly customized indices. We offer unbiased advice on the suitability of the index considering insurer's overall product portfolio, hedging costs and their risk management framework. We stand to gain nothing from favoring one manufacturer or component over another.