Benefits And Pensions Monitor Interview: Making The Case For Factor Investing
Authored By: Benefits and Pensions Monitor Staff | Publish Date: January 13, 2017
Authored By: Benefits and Pensions Monitor Staff | Publish Date: January 13, 2017
BPM: What is the history of smart beta?
Alexander Davey: The name ‘smart beta’ was coined by a large investment consulting firm for a conference. They were looking for a different type of index because, ultimately, its performance was still embedded strongly to look like a market cap index. They said, ‘It’s like a smart beta,’ and the name stuck, much to the chagrin of many people in the industry. It’s probably better termed ‘factor investing,’ which tries to outperform the market cap index. It isn’t necessarily a typical active fundamental process with a team of analysts and a portfolio manager. There is usually a representative index or a quantitative format representing the investment engine.
Your classic passive investment approach is predicated on a standard market cap benchmark. You have a market cap benchmark and the proposition to a client is you can pay an active manager to try and outperform that benchmark or you can just buy the market. You won’t outperform the market, but you will pay less in costs and, if the market goes up, so do your investments.
However, over time, equities will give more of a return than cash and bonds. Then buying an index tracker means I will capture that return.
The hybrid point includes factor investing and smart beta where you say, ‘There are elements that look like the passive part, a broadly diversified portfolio, a large number of stocks.’ Potentially, this is delivered as an index, it may just be that it’s a strategy. The cost is likely to be lower, but the risk is that I could outperform or I could underperform. So, I bear the same kind of risks as if I was investing in an active portfolio.
The challenge for factor investing portfolios, or smart beta portfolios, is explaining the opportunity and the risk to investors in a clear manner, one in which they can understand what it is that they’re gaining exposure to and why that’s going to be positive for their portfolio over time. That’s the challenge with any active portfolio in terms of active risk away from the benchmark. Certainly that’s key when we talk about a pension fund moving from an active manager into something a little bit different.
Ultimately, it is about delivering an outcome which is better than the market capitalization benchmark.
BPM: Is part of the rise of smart beta and factor investing about the fact that it’s getting hard to find alpha?
AD: We’re absolutely looking for alpha. A smart beta strategy is still going to require that you believe that markets are inefficient. It may be a slightly different way to say, ‘How easy is it to find manager skill?’ It is a contentious subject, but the data does not stack up positively for the larger number of portfolio managers. There are undoubtedly talented portfolio managers out there, but one of the big arguments for passive investing is picking those managers and staying with them. Because of turnover costs, it’s very difficult. Therefore, passive is an easy default option.
Most investors probably intuitively do not believe markets are entirely efficient. So, if there is an inefficiency of price, then there should be an opportunity to generate this excess return.
Factor investing says if we can find a more systematic way to take advantage of that and find definable premiums that exist ‒ value being a good example ‒ over time, if holding a portfolio of value stocks outperforms the market and if I can get exposure to that, then that will be a better driver of return. So I don’t need the manager skill bit here. In effect, a lot of excess return can be co-defined as factor exposure.
The cost of a factor investing smart beta portfolio is similar to passive, whereas the cost of an active portfolio may be two to three times higher. When you think about that in the context of compounding up that fee differential for a similar level of performance, it becomes an easy decision. I think that explains, in part, some of the move from the active world.
Interestingly, we see quite a move from both passive portfolios and active portfolios into smart beta and factor portfolios. The fees bit is a bit disruptive because the world is now on a continuum that looks like a barbell.
At one end, the majority of investors, pension funds and official institutions, are comfortable paying for active management when they believe that skill exists. So that will be higher tracking error portfolios and in areas such as private equity, infrastructure, and hedge funds where there is a real skill set to the manager. You allocate your costs where you think you get the benefit.
At the other end, although not passive portfolios, there are fees that look similar to passive portfolios. We’re seeing a strong move that says a smart beta portfolio should look and feel, cost-wise, like a passive portfolio because of the level of work that is required.
In that respect, smart beta becomes hugely disruptive to any of the active community that sat in the two to four per cent tracking error range where they were hoping to charge 50 to 100 BPS for delivering index plus a little bit of performance. We’ve seen a number of articles about closet index tracking. If you think you can add value, you get out to the far end of the continuum, but bring a bit more volatility and tracking error to justify the fees that you’re going to be charging to a client.
BPM: Where does it fit into the spectrum of things? Traditionally, when markets are going well, investors move into active investment because they can see the potential for the excess return. When markets go down, they would start migrating into passive investment because they were prepared to sacrifice some upside return for protection on the downside. Do we see the same sort of thing happening as markets fluctuate with factor investing?
AD: Yes, and perhaps to a greater degree. In the factor world, you have the opportunity to invest into low beta or low vol portfolios where the position is ‘we think we can deliver a return that looks similar to the market, but we think we can do it at around 75 to 85 per cent of the volatility.’ So you are genuinely offering downside protection.
Moving into passive market cap away from active says: I’ll give up the chance for outperformance or the worry of underperformance to just get the certainty of return of the market. However, if the market is down 30 per cent, I’m getting no cushion against that, I’m just following it down.
A low vol portfolio should be able to truncate some of that draw down. Obviously, if I’m still running 75 to 85 per cent of the beta, I’m not removing it, but I am at least getting a cushion. The mathematical part to this is that if I lose less, I can gain quicker. So if I truncate some of that draw down, then if markets start to recover I actually can accelerate back up a heck of a lot quicker.
There’s an example where a factor investing portfolio, if an investor started to feel uncomfortable with the equity market dynamic, would give them the opportunity to add some form of potential protection without having to veer into the world of derivatives or otherwise, but still hold similar names of stocks that they were familiar and comfortable with. So you’re not making a sudden esoteric move into a different investment universe. That’s clearly an opportunity that doesn’t exist simply pulling the arms of a passive portfolio. In an active world, to get something similar, you would potentially need to be employing a manager who had the capability to move from equity to cash.
The allocation decision is based on the investment mandate. It’s on a case-by-case basis for funds, but there is a bigger asset allocation decision as to the leeway you give a manager whether it is at the pension board level or trustee board level.
The factor investing element gives the capability to look at lower volatility and construct more defensive portfolios by trying to harness factors such as quality, value, and low beta to construct a longer-term portfolio that is more defensive in nature.
A pension fund portfolio with a 40 to 45 per cent equity exposure means that exposure runs roughly at 75 to 80 per cent of the risk. The board might decide they are comfortable with that allocation level, but their issue is more with the risk. Pulling the levers of a factor portfolio may enable it to continue to hold the same allocation level, but reduce the absolute risk. That could be a simple shift into a low vol portfolio or it could be by customizing a factor portfolio that looks at multiple different signals.
The capability to customize a portfolio around geographical, volatility, tracking error, factor, and factor constraints becomes very meaningful because it starts to deliver certainty. That’s not true across every smart beta product and that’s where, again, you see the term covers a myriad of different portfolios.
Initially, we’ve seen a lot of the early products were delivered as an index. There are the Research Affiliates’ RAFI indices and a number of ETF providers run those in the U.S., Canadian, Europe, and other markets. HSBC launched its HSBC Economic Scale Indices. There was an idea you then delivered this as an index and invested the portfolio in line with index. Given this was no market cap, it could be termed an alternative index.
There has been an increasing interest in the idea of factors and then in how you create multi-factor portfolios. The issue with a single factor is if value is out of favour, then in the short term there may be a performance issue because the portfolio may underperform the market index; even if you outperform it over seven to 15 years. A multi-factor portfolio could blend several factors together, reduce the cyclicality of a single factor and still offer outperformance. It may also remove some of that potential headache in terms of over exaggerated style bias. This change has been an interesting dynamic in the market.
The other part of multi-factor portfolios is the asset allocation decision of the pension fund is being pushed back to the asset manager. A factor portfolio in a systematic world quite often is able to embed constraints like, for example, environmental, social, and governance, far more easily than a more active process where there is a very defined set of views and judgments.
Indices are relatively blunt once you set the rules and you can’t legally adjust them every single week or month. You can adjust them, but there is a duty of governance around not shifting things too dramatically. You don’t want a sequence where your investors are suddenly having to switch indices every couple of years to try to take on a new idea.
BPM: What has the uptake been amongst institutional investors?
AD: It’s been relatively strong, particularly globally at the top 500 global institutions including the plans in Canada, the U.S., and some Asian investors. In Europe, there was an early uptake of the idea.
We’ve noticed a stronger engagement around what’s next. For example, investors may have some a low vol or fundamental index in place, but they’re looking next at a specific or series of factors or a multi-factor portfolio. That’s where the terminology gets reinvented where factor investing may be a better name than smart beta because it better represents what the investor base is trying to achieve.
That’s where we see the growth, where we’ve seen a lot of RFPs, and where we’ve seen a lot of conversations happening. For many investors, there has been a baby step into an initial product and then a secondary step to augment factor exposure.
This doesn’t mean a wholesale rejection of the status quo. If you have a very good active manager who is hugely value biased, you might decide you don’t want to do anything with that because he or she has delivered a lot of excess return over time, but your overall portfolio needs to be a bit more neutral. It could be that a well-balanced, well-constructed factor portfolio starts to adjust the overall portfolio mix, maintains the capability to deliver equity returns, and doesn’t disrupt a manager who’s done a great job. In that sense, a factor portfolio is highly complementary and more of a completion strategy.
BPM: With defined benefit world plans in different phases and stages including many that are closed and just managing their assets until they wind up, does this have liability driven investing (LDI) implications?
AD: If you look at an LDI solution, you’re probably going to see somebody immunizing their portfolio and just buying a big ladder of bonds. Plans with a deficit who say they have to increase the return on the portfolio to get from 75 to 90 per cent funded are going to struggle to do that by buying a ladder of bonds. That’s where I think you start to see the desire to take on equity risk and then their decision-making around how they do that and to what level do they want to add performance.
But in a deficit situation, how much do you want to give up in fees to do that? There’s an awkward tug of war between making an immunized decision, which is easy, but if you’re in deficit, it is difficult because of the need to ramp that the return up. You need the belief that an equity risk premium exists and then make a conscious decision about how much cost you’re willing to pay to increase the opportunity to add a bit more to that premium.
However, the majority that have gone the LDI route don’t really want to disrupt too much. They just want to get everything in place and then leave it to run off as the bonds mature.
BPM: This time next year, will anybody still call it smart beta or will you have converted the world to factor investing?
AD: I think the smart beta name will stick because it encompasses a lot of different strategies. The majority of those are index-based or quantitative systematic and in aggregate they all have a broadly diversified number of stocks and are looking to outperform the index.
The shift is around investor engagement. You asked a very interesting question about the take up and what we’re seeing here is that there was a lot of smart beta fatigue when it was just a lot of people at conferences throwing out ideas. But as it becomes meaningful to the investor base, they’re articulating very clearly what it is that they like about parts of that investment area. That’s beginning to define what a fundamental or smart beta index is as well as what a factor strategy is.