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Index funds: Welcome to the third way

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21 Mar 2022

Index investing is changing in a bid to manage risk better. Andrew Holt looks at what investors need to know about the new hybrid funds hitting the market.

Hybrid Funds

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Index investing is changing in a bid to manage risk better. Andrew Holt looks at what investors need to know about the new hybrid funds hitting the market.

Hybrid Funds

A new breed of index fund has appeared on the investment block. These “third way” index funds offer a combination of active and passive styles. And, for the right institutional investor, they provide a huge benefit.

But what exactly are they? “They rely on a systematic rules-based style of investing, long used by quant managers,” says Amin Rajan, chief executive of Create Research, a boutique specialising in strategic change in investment management. “However, their substantive adoption in the pension world only gained traction after the 2008 crisis, when conventional asset-based diversification came unhinged when it was needed most.”

This, says Rajan, brought into focus the Yale model, which favours alternatives. Yet it did just as badly as the long-only model, favouring mainstream assets. “It was a cathartic moment when pension plans started looking at investing through the lens of factor investing,” he adds.

This approach rests, essentially, on strong evidence that seemingly different asset classes can have unusually high correlations, due to their common exposure to underlying risk factors. “These are the smallest systematic units that influence investment return and its associated risk,” Rajan says. “Factor investing is seen as a third way of investing that combines the best of actives and passives while compensating for their respective weaknesses.”

Factor calls

The active component relies on portfolio managers to make calls on which factors to choose, what data to deploy and when to dial up, dial down or switch off a factor. The passive component, in turn, relies on the low costs associated with a rules-based systematic strategy that is a lot cheaper than traditional stock picking.

Deborah Fuhr, managing partner at research and consultancy firm ETFGi, says there is some crossover between factor investing and smart beta. “For factor and smart beta in general, it is factors where academic research that shows if you invest in them for long-time periods you will do better than the market cap.

“In terms of smart beta investing, it is able to tilt quickly to a factor you think is going to perform well, at any time and in any size you want while not having to adjust your core holdings,” she adds.

Value drivers

These new index funds have the benefit over their traditional counterparts in that they do not have to invest in overvalued stocks, unless they want to. “By tracking traditional market indices, such as the FTSE100 or S&P500, passive funds are overweight large expensive companies at the expense of lower-priced small companies,” Rajan says. “Large ones attract new money owing to their sheer size rather than their intrinsic worth.

“The resulting momentum overinflates market values in the upswing,” he adds. “It also causes extra volatility in the downswing, as subsequent corrections overshoot intrinsic value.” Factor investing, in contrast, focuses on value drivers at different stages of the market cycle by switching between factors.

“This is deemed to offer a more robust diversification via a lower correlation among its constituent risk factors,” Rajan says. They were developed for one key reason: the recognition that traditional diversification failed when it was needed most – in bear markets – when the correlation between historically lowly-correlated asset classes went through the roof, thanks to their exposure to common risk factors.

Reasons to be cheerful

They offer institutional investors two benefits. “First, they have a more rational basis for diversification,” Rajan says. “This is especially relevant now as, with rising inflation, the equity-bond correlation will turn positive and remain high, if history is any guide. Second, the cost is much lower, so they can potentially offer cheap alpha returns at near-beta fees.”

In addition, as most active managers have struggled to beat their market benchmarks, factor investing has appeared a more credible option for accessing alpha.

Among institutional investors, mostly large pension plans with the necessary skillset and governance structure are using them. Some are engaging in factor investing by relying on their in-house team of investment professionals.

This is evident with the €120bn (£99.9bn) Danish pension fund ATP, which uses factor within its multi-layered investment portfolio. Christian Kjær, ATP’s president and head of liquid markets, enthuses about the use of factor investing. “In broad terms, the factor investing approach has been successful,” he says. “We have generated high, risk-adjusted returns from diversifying equities, bonds and inflation.”

Right risk

Having a risk capacity constraint, rather than a capital constraint is one reason why the fund uses such an approach. “A risk capacity constraint is important for how we have set up the investment portfolio,” Kjær says. “The task in the investment portfolio is to have as much risk in the portfolio as we feel is suitable and are comfortable with. So, getting the right level of risk is the first and foremost objective of the portfolio. We believe returns are primarily driven by risk.

“Secondly, it is creating the highest risk-adjusted return. So, one is getting the risk right, and two, is getting the right risk. “The task of creating the highest risk-adjusted return is why we end up in this factor world,” he adds. “We believe it is the best strategy to achieve a high-adjusted return is via diversification.”

ATP has three primary factors: an equity factor with 35%, an interest-rate factor of 35% and an inflation factor of 15%. “We have what we call other factors, which has a risk strategic level of 15% – it is a lot lower at the moment – and this is where factor strategies come into play in this other risk,” Kjær adds. “Here, when we have taken out everything from the traditional investments: equities, bonds, inflation and commodities, we look for these dynamic strategies to give us something extra.”

Many factors

Factors come in many flavours. As well as what Kjær at ATP highlights, there are macro factors, such as GDP growth and volatility. Then there are equity-specific ones that are broken down into size, value, momentum, variance and currency. There is also a choice between bond-specific ones like capital structure, duration, credit spread and default risks.

It enables pension investors to understand three things: the sources of risk and return at a more granular level, the time-varying nature of risk premia and the key drivers of correlation between all asset classes. “Early experience suggests that their returns have been more sensitive to rebalancing than the choice of risk factors per se,” Rajan says. “Even so, this risk factor approach is seen as a significant advance.”

Index managers will need to become part asset manager and part software developer if they want to be successful in the new world order.


Shaun Murphy, Polaris Global Advisors

Investor development

The move to factor also comes from a better understanding of risk, notes Shaun Murphy, president of consultancy Polaris Global Advisors. “Many institutional investors have become more sophisticated and now better understand how risk factors can have an effect on plan assets,” he says.

“Factor investing is an area we have increasingly seen institutional investors using to understand, quantify and control risk within an individual portfolio or across plan assets. And a significant number of pension plans have invested in technology that can help them analyze risk exposures within their portfolios,” Murphy adds.

This is a point that resonates with Kjær. “Getting the infrastructure – setting everything up electronically – up and running was hard work, but it has been worth it,” he adds. “If you want to do this in-house, you need to have a strong infrastructure.”

However, data in this segment of the market is hard to come by. The managers and investors concerned use their own proprietary definitions of the factors used, so it is hard to find information that is directly comparable or consistent.

But without doubt, it is an expanding universe. “Investors now have an infinite universe of investment strategies available to them to match their own unique goals and objectives,” Murphy says.

Test delayed

There are two other interesting points. One is that before the pandemic, when factor investing was becoming all the rage, it was believed that it would be best judged not by inflows while markets are artificially inflated by central banks, but by their resilience when the next big market correction came.

“However, that test has been delayed by the unprecedented intervention by central banks in March 2020 following a market rout,” Rajan says. “It has driven valuations to nose-bleed levels and severely distorted the markets.”

Secondly, and equally import, there is no guarantee that a factor’s historical returns will persist. “Factors can become overvalued as they attract new money,” Rajan says. “Individual factors can be cyclical and underperform over extended periods. For this, look no further than the plight of the value factor over the past decade. Much depends upon investors’ ability to stay the course.”

Need to know

While factor investing can provide a good blend of index and active investing, it should come with disclaimers, Murphy says. “I would argue that there are pros and cons to factor investing and understanding the trade-offs is key before implementing,” he adds. “Plan sponsors and asset owners should be aware as to how factors are being defined, how they interact with other factors within the portfolio and how they may perform in different market environments.”

The index management business has experienced significant change during the past 20 years which is likely to continue – possibly at a more rapid pace. Index managers are, therefore, at an interesting crossroad, where they will need to adapt and evolve their capabilities to remain competitive.

“With so many assets, and so much revenue at stake, [index managers] may well need to find ways to position themselves on multiple parts of the value chain,” Murphy says. “The increased demand for flexibility and scale will force managers to invest in areas such as data extraction, risk modelling and analytics, which need to be provided at a reasonable fee level for the investor.”

Instant access

Technology will inevitably play a huge part in how this can be achieved. Tools that portfolio managers use may also need to sit on a client’s desktop, Murphy says, so they can instantly access their assets as well as helping them to feel more integrated into the investment process.

“Index managers will need to become part asset manager and part software developer if they want to be successful in the new world order,” Murphy says. This in turn is likely to mean more developments in the index funds space.

So how should investors approach this evolving landscape? “I would advise an investor to try to understand the design of the index funds they are looking to invest in,” Murphy says. “This will mean looking for index funds that are transparent in their methodology, which will help predict what outcomes could look like in different economic environments.

“And make sure the asset owners investment staff and especially trustees are comfortable with the linkage between their goals and objectives and the index funds utilised,” he adds. If done, then the commitment can be worth it, Kjær says. “We wouldn’t be where we are today if we hadn’t taken this journey.”

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