“The cap-weighted indices are based on share prices and vary when share prices move,” says Stuart White, head of institutional UK at HSBC Global Asset Management. “There is a tilt towards large cap stocks and there can also be concentration risk. The problem is that in bubbles such as the Japanese in the 1980s and technology at the beginning of the century, investors were exposed to higher weightings in stocks which fell sharply in value. As for active managers, there is always a place for them, although choosing consistent outperformers is always a challenge. The result is that pension funds are looking at how they can be more efficient.”
ONLY FOR THE LARGEST?
According to a study by State Street Global Advisors, which surveyed 300 institutional investors, the majority see advanced or smart beta as a replacement for active and are three-times more likely to fund an allocation from active rather than passive. Two-thirds of respondents, mainly from public and private pension schemes, insurance companies, endowment funds and foundations, believe the strategy was here to stay. However, as Sorca Kelly-Scholte, managing director, client strategies & research, EMEA at Russell Investments notes, smart beta or alternative indexation are still mainly the preserve of the larger pension funds.
“Our survey found that only 9% of pension funds managing less than $1bn had allocations, compared with 46% for those with over $10bn in assets. Almost half of the smaller funds said they had no plans to start evaluating putting money into these strategies while around a tenth ruled it out altogether.”
This explains why it is has only been the pension behemoths and organisations such as PPF and NEST that have made commitments. In Europe, early adopters include Danish fund PKA, the Dutch funds, PNO Media, PGGM and APG. They have different slants with PGGM, for example, having allocated 40% of its equity assets while fellow Dutch fund APG started building smart beta exposures for commodity markets in 2009 before moving on to implement minimum volatility quantitative equity strategies three years later.
COMBINING STRATEGIES
Over the years, the number of strategies has proliferated ranging from those that have market constituents equally weighted to fundamental indexing whereby each company is weighted by its financial characteristics – sales, dividends, assets or cashflow. There is also the factor-based group – quality, value, size and momentum – which are a set of investment characteristics that explain the risk and return behaviour of an asset or stock. Another popular strategy especially post-financial crisis is the low volatility and minimum variance index.
“There is no one smart beta solution,” says Isabelle Bourcier, head of business development at Ossiam, a subsidiary of Natixis Global Asset Management. “I would not recommend having just one strategy, but a combination of three to four in order to manage correlation.”
Dimitris Melas, head of new product research at MSCI, an index and analytics provider, which has over $95bn benchmarked to its factor-based indices, agrees “the majority of investors will combine two to three with low correlation such as quality, value and momentum. However, certain investors will only select one because they feel comfortable with that approach while others have a specific objective in mind such as lowering volatility and they will be attracted to minimum variance. Larger funds like NEST may start with one or two and then add more at a later time.”
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