If alternatives to market cap-weighted indices can be obtained cheaply, might they offer a cheap form of diversification for DC schemes? And what would happen if everybody has the same idea at the same time? David Rowley reports.
“Research has shown that alternative strategies such as factor-based investing and smart beta can outperform a market cap approach over the long term.”
Matt Fuller, Kingfisher Pension Scheme
There is a growing opinion that alternative indexation has a role to play in defined contribution (DC) schemes. The main driver is the belief that purchasing an index constituted by value, momentum, low volatility or quality with a rationale for why, makes for a better due diligence story than the simplistic purchase of a market cap constructed ‘passive’ equity index. Secondly, the price of accessing these strategies has fallen and is expected to fall further.
A third reason, which tends to rank lower than the first two, is that if smart beta is timed correctly it can eke out more returns amid widespread gloom about the prospect for equity valuations. This approach is described somewhat dismissively as ‘active lite’, but it does come with fees that will subtract less from what are predicted to be low returns over the next few years.
The first argument is the most prevalent and this is why Matt Fuller, pensions investment manager at the Kingfisher Pension Scheme thinks it has merit.
“Research has shown that alternative strategies such as factor-based investing and smart beta can outperform a pure market cap approach over the long term,” he says. “In a similar way that schemes may consider diversifying across different asset classes to attain better outcomes, it would seem sensible for schemes to consider diversification within their passive equities by looking at alternative strategies in addition to a traditional market cap approach.”
Other CIOs such as Robert Waugh at the Royal Bank of Scotland also see the sense of this reasoning.
Fuller cites research published by the Cass Business School in conjunction with Aon Hewitt in 2013 which looked at data on the 1,000 largest US stocks from 1968 to the end of 2011. This found that many alternative indices would have produced a better risk-adjusted performance than a passive exposure to a market-capitalisation weighted index.
