Pension funds and other institutions are increasingly considering smart beta and factor strategies as alternatives to active and purely passive management, amid falling returns and pressure to cut costs – despite questions about how truly smart such investments are.
AsianInvestor understands that some superannuation funds in Australia are looking more closely at smart beta. Melbourne-based Cbus Super, the A$34 billion ( $25.76 billion ) pension scheme for construction and related industries, is one institution using such strategies.
Meanwhile, Hong Kong’s $7.2 billion Hospital Authority Provident Fund Scheme (HKHAPS) implemented its first smart beta mandates last month, as reported. The New Zealand Superannuation Fund has indicated it intends to include smart beta in its portfolio mix. And some institutions that have already adopted the approach, such as Taiwan’s Bureau of Labor Funds (BLF), are increasing their allocation.
Growing focus on fees
Gabriel Szondy, director of the $10 billion CareSuper fund and a veteran of Australia’s superannuation industry, told AsianInvestor: “Fees take up a far greater significance in a period of low returns. That’s why many US managers who are coming to Australia now trying to sell private equity and hedge funds have gone back with their tail between their legs, because the Australians are not willing to pay 2% [as the management fee] and 20% [performance fee].”
Although not an advocate of smart beta, he added that the relative costs were a key aspect that Australian asset owners considered when they look at smart beta strategies. "It’s essentially enhanced passive, and that’s all it is, so the costs have to reflect that”.
Brett Chatfield, investment manager for public markets at Cbus, agreed that cost was a factor when using smart beta. The fund uses two alternative beta strategies (low volatility and fundamental indexation) in its global equities portfolio, with a total allocation of 15% (around US$1.13 billion).
Cbus uses low volatility to balance its exposure to higher-volatility active fundamental managers and to raise its allocation to defensive equities when required, Chatfield told AsianInvestor. Smart beta also provides diversified exposure and should produce superior risk-adjusted returns underpinned by the low-volatility weighting, he said.
Fundamental indexation largely provides an allocation to value, which helps balance the portfolio against several growth-oriented fundamental managers that Cbus uses. It enables the factor exposure to be achieved at a relatively low cost, said Chatfield.
Ultimately, simple exposure to equity beta will no longer be enough for investors to achieve their return targets, said US asset manager Pimco in paper published earlier this month. Interestingly, the firm, a bond fund specialist, was making an argument for the benefits of smart beta in equity portfolios.
Equity indices enjoyed a bull run following the 2008 financial crisis when it was difficult to argue against cheap yet powerful beta returns, said Andrew Pyne, Pimco’s product manager for equity strategies and co-author of the report. But that run of high returns and low volatility is over, he noted. So what should investors do now?
The pressure on fees does not mean investors will only use passive strategies. Traditional active managers have struggled recently, in part because factor biases, such as value or size, have meant they have been unable to add value using their their stock-selection skills, Pyne noted.
There is nothing inherently wrong in an active manager tilting portfolios towards specific factors, he added, but for institutional investors there are far cheaper options, including smart beta.
Fiona Trafford-Walker, Melbourne-based director of asset consulting at Frontier Advisers, said her institutional consultancy was now looking more closely at smart beta, for various reasons. For example, it can be used as a benchmark for active managers, she noted, for investors who want to boost their exposure to value factors.
Trafford-Walker said Frontier was looking at smart beta more for its larger clients, and whether it should be a bigger part of their activity. “Capacity constraints hit pretty quickly with high-quality managers." Multi-billion-dollar funds need to find places to put their money, and smart beta might be a way of getting cheap access to certain factors, she added.
Smart-beta products can also be useful for monitoring and understanding what’s driving the portfolio, noted Trafford-Walker, as funds seek to drive down costs by taking some functions in-house.
She said she was seeing more flexibility from fund managers around reducing fees in this environment, where funds are either altering their active management approach or taking more investment management in-house. "It's about flexibility and control but also about bringing fees down, and that is causing more change than anything."
Of course, for some institutions it's about more than just keeping costs down. BLF chief investment officer Huang Chao-hsi told AsianInvestor that the pension fund had diversified into multiple smart beta indices to reduce the risk of single factors and earn more stable return.
The NT$3.4 trillion ($106 billion) entity had a total exposure to smart beta representing 33% of its foreign mandate as of June 30. It has just finished the selection of managers for a $2.1 billion enhanced Asia-Pacific mixed equity mandate; it uses a composite benchmark comprising minimum-volatility, quality and enhanced-value indices. BLF plans to announce details of the new mandate later this year.
Challenges for smart beta
While the willingness to embrace different factors is there, however, the problem of finding value within the individual factors is likely to be increasingly challenging.
Indeed, some asset owners are not convinced by the ‘smart beta’ approach. Mohamad Nasir Ab Latif, deputy chief executive of Malaysia’s $161 billion Employees Provident Fund, has said he does not see smart beta as an effective approach, because “the moment everyone invests in the same way, the arbitrage disappears”.
Moreover, there are concerns that investors have been chasing performance by investing more in expensive factors such as low volatility and that a sharp reversal of this trend is likely to hurt portfolios. Large passive manager State Street Global Advisors suggests some aspects of this argument may be overstated.
So how to tell whether smart beta is really smart? Pimco has devised a checklist it hopes can help investors in this regard. Selecting the right systematic equity or smart beta provider demands the same kind of analysis that should be applied to active managers, said Pyne:
- Is the strategy over-reliant on back-tested results, or is there a live track record to evaluate?
- Does the manager offer an intuitive and rational explanation or is the model more of a black box?
- Is the strategy over-simplistic, which could lead to unintended consequences such as high industry concentration or exposure to value traps?
- Does the strategy take into account liquidity and transaction costs, which affect capacity and implementation?
- Are the models static or do they evolve and incorporate new insights driven by ongoing research?