The likelihood of ongoing volatility during 2019 is causing more asset owners and consultants to ponder the impact on their mounting exposures to passive investment.
The traditional pension fund core-satellite approach to asset allocation has seen a shift to better accommodate passive, or index-tracking investment, in recent years, with index replication strategies and smart beta ETFs finding their way into the core investment portfolio, along with multi-asset funds.
This change has displaced traditional institutional equity and bond portfolios that previously held direct investments as the core. It raises the question of whether these new approaches bring with them unforeseen risks.
Under the core-satellite approach, asset owners manage market risk and interest rate risk in the core of their investment portfolios, while they hold less-correlated idiosyncratic risks in satellite parts, where they can pursue riskier strategies such as unconstrained investing.
However, the rise of passives is recalibrating the traditional core-satellite model.
“Passives are reshaping the investment universe, notwithstanding their potential drawback,” said Professor Amin Rajan, chief executive of Create Research. His organisation has carried out various studies of allocation by pension funds and the contribution of different factors and strategies.
The immediate beneficiaries of this shift in the core space have been cap-weighted passive indexes, Rajan said. But Create’s most recent report on passive investing, ‘Reshaping the global investment landscape’, published in June, highlights how the rise of ‘smart beta’ ETFs is blurring the distinction between passive and active fund management.
Rather than track traditional market value-weighted indexes, smart beta funds instead follow indexes that are created and weighted according to factors such as value, volatility and dividend yield. While the ETF will passively track this index, its construction can be considered active in nature.
However, most of these passive-active smart beta approaches are relatively recent in nature; the concept has only gained appeal over the past seven years. Most strategies haven’t yet been stress-tested by time or financial market disruptions.
Some critics of passive funds (many active asset managers sit in this category) have suggested that passive funds have benefited from the one-off boost of post-global-financial crisis unconventional monetary policies, such as quantitative easing. Detractors also question the systematic dangers that may be building due to what Rajan calls a “relentless concentration of assets in monolithic indices on autopilot”.
In Create’s survey of global investors for the report, which covered 153 pension funds and a global investor base with assets under management of nearly $3.5 trillion, almost 70% of respondents saw passives as buying yesterday’s winners and over-inflating valuations, disconnecting index constituents from their fundamentals and making indexes more informationally inefficient over time.
As a result, over 50% reported feeling that passive funds could potentially destabilise markets and undermine the diversification they have promised.
At the same time, asset owners are finding that active managers can often veer toward passive, or benchmark-leaning, behaviour – while charging substantially higher fees. For example, Australia’s Future Fund analysed its listed equity managers to discover that “knowingly, or unknowingly”, they are taking large factor positions.
The fund’s CIO Raphael Arndt told AsianInvestor: “If we want factor exposures, we can access factor indexes much more cheaply without paying active management fees.”
A factor index fund may charge only 10 basis points (bp) in annual fees, versus an active manager that might have a fee of 50bp or more.
Ardnt’s conclusion was that “the world has fundamentally changed, requiring a new approach to active equities investing”. It’s something Future Fund is trying to create.
While some asset owners question the validity of passive investing, others have fully embraced the concept. Most notable is Japan’s Government Pension Investment Fund (GPIF). In March 2018 the ¥165.61 trillion ($1.4 trillion) fund introduced a new fee structure, under which it said it would only pay for outperformance among its active fund managers. Active funds that only match or underperform their benchmarks will only receive passive fund fees.
FEE FOR PERFORMANCE
“As a universal owner, GPIF owns 80% of its assets by passive investment. Passive investment is based on an efficient market, and active investment is indispensable for the market to be efficient,” GPIF’s CIO Hiromichi Mizuno told AsianInvestor. “We hope that introducing the new performance-based fee structure will lead to a more efficient market.”
Instead of looking to active returns, GPIF and other pension funds such as Taiwan’s Bureau of Labor Funds have sought to increasingly use ETFs to gain smart beta exposure. Others are interested but wary.
For example, Dong Hun Jang, chief investment officer the Public Officials Benefit Association (Poba) in Korea told AsianInvestor he sees high demand for smart beta strategies to replace the existing core portfolio. “However, I think the smart beta strategy still needs to be tested over time and different market cycles.”
Jang acknowledged that “the satellite area [of the pension investment portfolio] still needs to generate alpha, which is getting harder to achieve”.
The Create survey showed that 40% of global investor respondents want improvements in their multi-asset strategies that blend active and passive investing approaches, including a deeper understanding of the correlation between component styles.
This story has been adapted from a feature in the AsianInvestor December 2018/January 2019 magazine.