Pension schemes in the UK are investing more in factor-based equity strategies with an eye on improving cost-efficiencies, even as they continue to cut their overall exposure to listed stocks.
Having long invested heavily in passive equity, they appear to be ahead of many Asian institutions when it comes to ramping up their use of smart beta.
That involves using index weightings other than traditional market capitalisation – known as factors, such as reduced-volatility or value – to seek returns that are higher and/or uncorrelated to typical benchmarks.
HSBC’s UK defined-benefit (DB) fund – one of the country’s biggest with £28 billion ($36.8 billion) under management and 110,000 members – is a clear example of this trend.
The scheme has added around £4 billion in quasi-passive equity exposure in the past couple of years, chief investment officer Mark Thompson told AsianInvestor.
The fund invests in developed-market equities entirely through passive or quasi-passive funds, with a “climate tilt”, he noted. But in illiquid or less homogeneous markets, such as in alternative income-type strategies, it tends to go active.
“Although we believe you can get a premium from active management in some markets,” London-based Thompson said, “where we feel you can’t, we prefer passive or quasi-passive type management.”
According to its latest Statement of Investment Principles, HSBC’s DB fund had 14.9% of its portfolio in equities as of November: 8.2% in developed-market equities, 3.8% in emerging-market stocks, 1.8% in private equity and 1.1% in smart beta (volatility premium).
UK DB funds generally have been shifting assets out of active equity and into quasi-passive strategies in recent years, confirmed Mark Johnson, head of institutional client management at Legal & General Investment Management (LGIM).
DB scheme usage of factor-based equity assets is estimated to have grown by 17% a year from 2015 to 2017, according to data provider Broadridge, combined with LGIM estimates. That’s compared with an overall annual growth of factor-based equity assets of 22% over the same period.
Single-factor strategies – such as those weighted by value or low volatility – constitute the largest part of the UK DB allocation, around 50%, while multi-factor accounts for 30%.
However, multi-factor investment volume is expected to grow by 15% to 20% a year from 2017 to 2022, as against 5% to 10% in the case of single-factor investment, Johnson said.
The increase in passive allocations has happened while UK DB funds’ overall equity exposure has fallen and bond allocations have risen in a 10-year-plus de-risking trend.
The weighted average allocation to equities halved to 29.0% as of end-2017 from 61.1% in 2006, during which period bond exposure has roughly doubled to 55.7%, according to the latest Purple Book, published annually by the UK Pension Protection Fund.
DC SCHEMES TOO
Factor investing has also been growing in usage on the defined-contribution side. HSBC substantially employs quasi-passive strategies for its DC scheme – which, with £3.7 billion and 80,000 members, is again one of the biggest in the UK.
The bank uses a multi-factor fund with a climate change tilt as the equity default option for the DC scheme. Thompson said the plan developed the product with LGIM and index provider FTSE and transitioned to it in January last year, replacing its previous passive global equities mandate, which was also run by LGIM.
And in March the DC scheme added four passively managed regional equity funds focused on Europe (ex UK), Japan, North America and Pacific Basin ex-Japan. These, along with the active sterling credit strategy it added at the same time, brought its range of DC member-choice products to 18.
Similarly the National Employment Savings Trust (Nest), a government-backed DC workplace pension scheme set up in 2011, added a smart-beta “climate-aware fund” to its choices last year. The fund is managed by UBS Asset Management using a smart-beta approach but was designed in partnership with Nest’s in-house team.
Nest has £3.1 billion in AUM but is expected to grow very fast as its contribution levels are to rise this year and next.
Passive investments represent about 50% of Nest’s total allocation, deputy CIO John St Hill told AsianInvestor.
“We think that, where available, index management can be more efficient than active management. However, there are asset classes where index management is likely to be inherently challenged," he said.
“For bonds, it makes sense to use active managers because you can avoid some of the more indebted issuers and address issues around less liquid bonds,” St Hill added.
Separately, Coal Pension Trustees, which oversees the £21 billion of the legacy DB retirement funds of the UK’s now-defunct coal industry, has around 45% of its equity assets in passive investments and the rest in active or factor-based allocations. It declined to comment on whether it was likely to raise its factor investments.
In Asia, interest in factor strategies is also rising, something that is reflected by flows into smart-beta exchange-traded funds.
It tends to be the large state pension funds moving into factor-based mandates at present. The likes of Taiwan’s Bureau of Labor Funds and New Zealand Super Fund have been active in this area.
There has also been some take-up among smaller institutions such as the Hong Kong Hospital Authority Provident Fund Scheme.
Demand may well continue to grow as corporate pensions become more prevalent in the region. In South Korea, for instance, the government has been backing the development of such schemes since 2011.
In its June/July magazine issue, AsianInvestor will publish an in-depth feature on how UK pension funds are allocating and revising their investment strategies amid major changes in the retirement sector.