Pension schemes have had enough of high fees and poor returns. Is smart beta their chance of something better?
The active versus passive debate is evolving. A few years ago, an equity bull run mixed with pension schemes’ thirst for value for money hit asset managers hard. The phones of professional stock pickers were red hot as institutions demanded billions of pounds of their money back after becoming disillusioned with paying high fees for poor returns. The new strategy was to invest in funds that mirror the performance of indices, especially with equities trading at record highs. Now it seems that the money is on the move again.
Potentially beating the returns offered by passive funds while paying lower fees than those for an active manager has put the strategy on the radar of many risk-adverse but cash-hungry institutions.
The strategy, which is also known as factor investing, is pitched as somewhere between active and passive by combining elements of both. Instead of tracking an index, such as the FTSE 100, these products track the underlying drivers of performance, which are known as factors. There are many factors that investors could use to help achieve a desired outcome, but the most popular are stocks picked on their quality, low volatility, momentum, size, environmental, social and governance (ESG) and value attributes.
This investment approach is proving popular with a growing number of pension schemes, which have exposure to one or more factors to potentially reduce risk or to increase the chances of making a desired return. Investing in more than one factor is another way that trustees are using the market to limit volatility in the portfolio and is another reason why investors are bullish on this investment approach.
Indeed, more than $1trn (£772bn) had been put to work in this market by the end of 2017, according to data provider Morningstar. And last year, smart beta proved popular with institutions. Almost half of the global asset owners that index and data specialist FTSE Russell spoke to had an allocation to smart beta in 2017, up from 36% in 2016. This figure is expected to rise in the coming years.
Invesco PowerShares discovered that 42% of the 435 European institutional and retail investors it surveyed in November 2017 for Smart beta strategies: more bricks for portfolio building who do not use smart beta would consider using the strategy in future.
FACTORING IN RISK
Asset owners in the UK that have smart beta exposure include high street pharmacy chain Boots and the railway workers pension scheme, which is managed by RPMI Railpen. Looking to join them later this year is the London Borough of Haringey Pension Fund and Brunel Pension Partnership, a local government pool managing more than £30bn for 10 schemes. What is interesting about these schemes is that safety appears to be a major reason why they are using the strategy, more so than for growth.
RPMI Railpen has more than £700m at work in the market. It uses smart beta to invest in companies that have consistently performed in a strategy designed to mitigate the severity of any momentum crash that might be coming down the road. It has also invested in high-quality value stocks and more stable small caps. Safety appears to be at the top of the agenda here, just as it is for the Boots Pension Scheme.
Boots handed Legal & General Investment Management (LGIM) £7.2bn in July 2017. LGIM, which manages £35bn in its factor funds, used Boots’ capital to launch a multi-factor global equity fund for institutions. The LGIM Diversified Multi-Factor Equity Fund, managed by Andrzej Pioch, has a global remit to invest in stocks that offer value, low volatility and quality, while avoiding mega-cap stocks. The larger companies sitting at the top of the S&P 500 and the FTSE 100 are vulnerable to a market sell-off if investors turn bearish.
Other points of safety include it being a multi-factor fund. The plan is also to lower risk by investing in several regions and avoid being too concentrated on specific sectors.
Then there is Brunel Pension Partnership, which manages £30bn for local government schemes, including those for Bristol, Cornwall, Oxfordshire and the Environment Agency. In April it kicked-off a search for fund managers to take charge of two low volatility equity mandates, which could be worth around £600m combined.
Brunel’s smart beta mandates are designed to reduce the pool’s risk to avoid “valuation bubbles” and to include ESG-led factors in management’s investment decisions. “Low volatility is one of the most intriguing areas of the smart beta revolution and a good fit for investors seeking to reduce equity risk,” Brunel’s chief investment officer Mark Mansley said when launching the mandates.
Brunel is looking for managers who have a clear and consistent investment process and are committed to high standards of transparency. The idea is to generate longterm returns for lower costs, whilst reducing risk in the portfolio.
The London Borough of Haringey Pension Fund is to shift almost half (around 42%) of its passive equity portfolio into a multi-factor global fund, managed by LGIM. This is expected to happen later this year. Once completed, Haringey Council’s allocation to factor investments will be 9.6% its portfolio. This is, by any standard, a sizeable commitment.
Haringey’s investment committee acknowledged earlier this year that its equities, which account for around 45% of its £1.4bn portfolio, are the most volatile element of its portfolio. So it is taking action by moving them to what is perceived to be a safety asset class. Time will tell if this assumption will be proved to be correct.
It appears that the investment committee is concerned that within its equity portfolio the scheme is too exposed to large caps, which were probably trading on high multiples when the passive managers bought them. The move has been designed to protect the scheme against any sell-off in equities, which is already evident as investors start locking-in their gains following a prolonged bull run driven largely by quantitative easing.
It is not all about safety. Growth is a motivator, too. Anthony Charlwood, an investment manager at TPT Retirement Solutions, said during a roundtable hosted by portfolio institutional in May: “About a year or so ago, our investment manager suggested we move some of that pure index tracking exposure into global factor funds. We see the move slightly away from pure index-tracking funds to factor funds as a way of harvesting some additional alpha. “At the same time, although factor fund fees are higher, they are clearly lower than those for pure active managers,” he adds. “So by having a mixture of index-tracking funds and factor funds, we can still offer a competitive charge to employers and members.”
A CROWDED MARKET
Despite its rising popularity in terms of the capital flowing into factor funds, this is far from being a mainstream strategy. Allocations by institutions to smart beta are modest when compared to the size the other areas of their portfolios. Indeed, the £27.5bn Railpen pension scheme has only £600m in such strategies.
At the same time that Brunel’s Mansley launched the smart beta mandates earlier this year it also launched a search for two asset managers to invest directly in UK equities. At £1.2bn it is double the proposed size of the smart beta portfolio.
But at almost 10% of its portfolio, Haringey Council’s proposed moved into smart beta is one of the largest examples of an institution gaining exposure to the market.
Some schemes are moving into these strategies to prepare for a potential slide in equities. They could, of course, limit any volatility that is on the way, but these strategies should be seen as much more than that. They should be treated as a potential longterm provider of returns. So it is a strategy for the patient and the persistent as there will be times that investors might miss out on the gains made by index providers, so investors should take a long-term view.
Charlwood said in May that in the factor funds TPT is using, the emphasis is on persistent factors that over a reasonably long time would be expected to outperform.
“There might be certain market conditions where certain factors won’t, but again, it emulates back to this question of turnover,” he adds. “You can’t keep churning the portfolio or all the benefits are absorbed in transaction costs.”
So the benefits are attractive, but investors need to tread carefully before opening their account. Smart beta is far from being a golden goose of the investment industry.
There are criticisms that the factors are becoming expensive as too much capital flows into them in what is known as crowding. Then there are questions of whether the capital flowing into these funds has skewed their performance to appear more positive.
There are also concerns that some smart beta strategies have not been thoroughly tested. For example, how will smart beta exchange-traded funds (ETFs) perform if there is a sharp rise in interest rates? There is a danger that the prolonged low interest rate period that the research might cover may not prepare these products from hawkish members of the Bank of England’s monetary policy committee.
Then there are worries over the quality of the data. It is, after all, what the strategy is based on. Does compiling the data for smart beta factors actually remove bias in the stock picking process? Has the data been tested on a strategy until those behind the fund have the result that they want? As always, past performance is not a guarantee of future results. Looking back may help assess what performed well or remained steady during previous market turbulence, but there is no guarantee that they will be immune from future sell-offs.
These are questions investors need to answer before gaining exposure to the market. Bias is something that they might not be able to avoid.
In smart beta, capital is allocated based on data rather than just blindly mirroring an index such as the FTSE 100, or relying on the skills of a professional stock picker, for which the fees are likely to be higher. The issue is that while active managers will use research when making their decisions, they are not bound by the latest report from the firm’s head analyst and could invest with biases to major names trading in the index.
Factor investing is supposed to remove these biases. So the active verses passive debate has become more about man versus research. It seems that a growing number of pension schemes are looking to see if a data driven-approach generates superior return with variable risk than a professional using their gut feeling. Time will tell.