Taiwan's Bureau of Labor Funds has postponed plans to employ enhanced indexing strategies in its fixed-income investments because it is struggling to find appropriate factor-based benchmarks.

The NT$4.11 trillion ($132 billion) pension fund had been mulling an investment mandate that would employ an enhanced indexing, or smart beta, strategy for its overseas bond portfolio, having already gone down that road with some of its equity investments.

Having not issued any new fixed income mandate in three years, the Bureau of Labor Funds (BLF) had wanted to do something “innovative”, Liu Li-ju, deputy director general of BLF, told AsianInvestor. “We thought that since equities can use the idea of multi factors, why it seems we can’t see [such a strategy] in fixed income allocations?”

Liu Li-Ju

Enhanced indexing, a hybrid of active and passive management, seeks to amplify the returns of a benchmark index by overweighting, underweighting or maintaining the underlying securities according to different style factors – which can include such things as momentum or value, or something altogether more technical.

However, the pension fund will now not be going ahead with the idea this year because it could not find the right benchmark after holding discussions with index companies, Liu said.

The challenge is to create a bespoke factor-based benchmark that promises to deliver a higher return than the mainstream market index. It's a complex process that requires much back-testing.

In the case of the mandate for emerging market equities BLF issued earlier this year, the requirement was for the projected annualised return of the factor-based benchmark to be 5% higher than the broader market index, she said. 

In March, BLF handed out a $1.5 billion emerging markets equity mandate with a multi-factor strategy to five managers who had to prove they could earn an extra 50 basis points more than the expected annual net return of the bespoke benchmark.

BOND FACTOR LAG

“When it comes to smart beta, definitely fixed income has been lagging equities,” Arom Pathammavong, managing director for indices at FTSE Russell, told AsianInvestor

The return that can be achieved with equities will always be higher than with fixed income exposure when both are using factor investing strategies, so the former one is more popular among investors. There are theoretically unlimited upsides in stock returns while bond yields and coupons have caps, Pathammavong explained.

The factors used in fixed income are also more technical to understand. For example, the factor “carry” in the equity space is linked to the dividend yield of the stock, while in fixed income it is related to the shape of the relevant yield curve and price gain on the bond, he said.

There are also practical obstacles for index companies when it comes to collecting data for compiling the benchmark. Stock markets are highly transparent and liquid, but it’s an over-the-counter market for bonds, so the bid-offer spread will be wider than on stocks, he said. And not every bond trades every day.

That said, a multi-factor benchmark for fixed income is still doable, Pathammavong said. So as institutional investors become more familiar with factor-based investing in equities, more of them are trying to see whether they can also apply such strategies within their bond allocations.

For BLF, though, a multi-factor bond mandate appears now to be on the back burner.

So for the rest of the year inflows into the pension fund will be allocated to its existing asset managers who outperform, as an incentive for them to continue generating higher returns, Liu said.

At present, BLF’s portfolio is almost equally split between domestic and overseas investments (see chart below).

About half of the investment assets are outsourced to external parties and they are mainly overseas investments, she said.

BLF's latest asset allocation