While smart beta is a much-talked about concept, implementation is slow. Part of the reluctance of investors is the risk of sustained underperformance, but that can be overcome by matching portfolio liquidity requirements with factor cycle duration. Amanda White speaks to Michael Hunstad, head of quantitative equity research, global equity management, at Northern Trust.

Sustained underperformance of a group of stocks according to a factor is a primary risk in factor investing, and further, the length of underperformance is not consistent across factors and so needs to be managed. But this provides an opportunity for investors to tilt their portfolios according to the time and liquidity needs.

According to Northern Trust research, cycles vary in length across common equity factors, from 12 months for the low volatility factor to 106 months for small size factor.

The research, which spanned data from 1979-2013, found the high value factor to have a cycle of 47 months, low volatility 12 months, high divided value 22 months, small size 106 months and high momentum 39 months.

In applying this research, Michael Hunstad, head of quantitative equity research, global equity management, at Northern Trust, says the combination of factor tilts depends on an investor’s time frame to liquidation.

Portfolios that are evaluated frequently or are near liquidation should opt for short-cycle factors like low volatility. Factors like size, value and momentum have long cycle lengths and should be held in long-term buy and hold portfolios.

Northern Trust says the optimal multi-period allocation of MSCI factor indices can be ordered according to time to liquidation.

Factors with relatively long cycles appear first in the portfolio to eventually be replaced by factors with shorter cycles.

As an industry, Hunstad says the discussion around smart betsa has moved past the initial stage of determining what compensation factors are and now investors are faced with the question of what factors to choose to tilt their portfolio.

He says the starting point for investors is to determine what their current portfolio factor allocations look like.

Northern Trust does this analysis for clients, strongly advocating that failing to base future investment decisions on a strong understanding of the current portfolio can lead to unintended bias or cancel out intended bias.

“For clients and potential clients we do mapping of their existing holdings and we see exposure to style biases exist, for example large cap. We’ve done it now for about 50-75 clients. The next step is to take corrective action so the portfolio can achieve their objectives, and then we discuss which strategies would work for them.”

Hunstad says in this way, even if a client has no intention of buying smart beta, it can be used as a way of thinking about risk.

Last year, Northern Trust conducted a quantitative survey of 139 global institutional investors to gain insight into how they were addressing strategic risk. It then looked at how “engineered equities” might better achieve the desired portfolio outcome.

The results outlined in the paper, Through the Looking Glass, found that only 18 per cent of the 139 investors surveyed felt they were certain of their overall equity portfolio’s actual factor exposures.

Further the survey found that regardless of the approach used to define the asset allocation –

asset liability management, core satellite, tactical or strategic – the portfolios didn’t always reflect the investors’ goals, objectives and intended exposures.

The paper says, to bring the portfolios in line with the investors’ expectations would require a substantial factor exposure – a deliberate and substantial commitment.

“One conclusion of the paper was that investors need to have to have a meaningful allocation to smart beta for it to be worthwhile, to actually move the dial on return expectations outside the noise of the portfolio,” Hunstad says.

In practice this is happening, and Hunstad says some clients are allocating 100 per cent of their equities portfolio in, for example, a quality, value blend or a quality, low volatility blend.

“You have to have a lot of conviction to do that,” he says. “More and more clients are realising it requires conviction. One client allocated 2.5 per cent of $10 billion but that doesn’t do anything.”

Hunstad says there are two variables in assessing factors – expense and whether it will be arbitraged away.

He firmly believes that while there is concern that, for example, low volatility will be expensive and the price is increasing, it doesn’t mean that low volatility will be unreliable or uncompensated.

This is due, mostly, to the total value of all smart beta being dwarfed by the total market – it’s less than 1 per cent, he says.

“It will never approach the volume you see in indexing, plus you see trades on the other side. It might be expensive or the wrong time for that factor, but it won’t be arbitraged away,” he says.

 

 

 

 

UK pension funds have not taking advantage of their comparative advantage as long-term investors and have not earned a positive long-run liquidity premium on their investments, according to a paper from the Cass Business School that examines UK pension funds’ monthly allocations to major asset classes over the period 1987-2012.

The authors – David Blake, Lucio Sarno and Gabriele Zinna – identify that the combination of herding behaviour of these investors and short-term automatic rebalancing towards a long-term optimal asset allocation, driven by their liabilities rather than by expected returns, can be obstacles to asset prices reaching their equilibrium values.

Published by the Pensions Institute at the Cass Business School at the City University London, the paper, The market for Lemmings:Is the Investment Behavior of Pension Funds Stabilizing or Destabilizing, finds that although UK pension funds are long-term investors they have not earned a positive long-run liquidity premium on their investments because their investment behavior is driven by different incentives.

“Pension fund managers fear relative underperformance against their peer-group, which encourages them in the very short term to herd around the average fund manager who turns out to be a closet index matcher,” the paper says.

“Further, their short-term objective is to rebalance their portfolios when valuation changes across different asset classes cause portfolio weights to violate investment mandate restrictions, while their long-term objective is to systematically switch from equities to bonds as their liabilities mature. Overall, our results show that pension fund investment behavior might be less stabilizing than previously believed.”

Analysis of the data by the authors finds that pension funds herd and, in particular, they herd in subgroups defined by size and sector type, consistent with reputational herding.

Pension funds also rebalance their portfolios in a way that is consistent with meeting their mandate restrictions in the short term and with maintaining a long-term strategic asset allocation that matches the development (in particular the maturity) of their liabilities.

This mechanical rebalancing could also be destabilizing if it has the effect of driving prices away rather than towards equilibrium values.

 

 

The paper, The market for Lemmings:Is the Investment Behavior of Pension Funds Stabilizing or Destabilizing, can be found here

http://www.pensions-institute.org/workingpapers/wp1408.pdf

The United Nations Environment Programme’s Inquiry into the Design of a Sustainable Financial System will present its interim report in Davos this week. The report has been initiated to advance policy options to improve the financial system’s effectiveness in mobilising capital towards a green and inclusive economy, and the interim report profiles innovations in five areas including institutional investment.

Here it explores policy changes in three broad areas: capital allocation, investor governance and market incentives in order to align the assets of institutional investors with sustainable development.

The report’s authors are positive about progress, saying that 2015 is poised to be the year of sustainable development, with growing focus on innovative policies to mobilise the trillions of dollars needed for long-term inclusive wealth creation.

The report identifies a number of high potential areas which could contribute to this shift including three major asset pools – banking, bond markets and institutional investors – as well as two emerging policy tools – monetary policy and ‘environmental stress tests’.

The UNEP Inquiry into Design Options for a Sustainable Financial System, now entering the second half of its two-year work program, was created to explore emerging changes and reforms to the financial system that would improve its alignment with sustainable development. Its investigations to date have revealed many innovations in financial and monetary policy, regulation and financial market standards.

The Inquiry is now half way through its work program and will complete its research and engagement at the end of 2015.

 

To access the report, Pathways to Scale, click below

 Inquiry – Pathways to Scale

The literature on how to optimally manage the investments of defined contribution funds is relatively scarce, despite the fact the growth in defined contribution continues to outpace defined benefit funds globally.

Now new research from academics at the University of Lausanne demonstrates how to perform an ALM study from a financial prospective for defined contribution plans.

The research finds that a liabilities hedging portfolio outperforms an assets-only strategy by between 5 and 15 per cent per year for the period between 1985 and 2013. This is due primarily to the fact that the optimal assets-only portfolio is typically long in cash, whereas hedging liabilities require the pension fund to be short in cash.

The authors conclude that: “This estimate suggests that allowing pension funds to hedge their liabilities through borrowing cash and investing in a diversified bond portfolio helps to enhance the global portfolio return.”

The article by Eric Jondeau and Michael Rockinger can be accessed below.

Optimal long-term allocation with pension fund liabilities

 

 

Asset owners, on average, add 15 basis points of value above their asset class benchmarks after fees, according to an extensive study by CEM Benchmarking.

The survey, which measured 6,666 data points from a global set of defined benefit plans, and some sovereign wealth funds and buffer funds, from 1992-2013.

Gross of investment fees, funds deliver 58 basis points of value added.

The study highlights why costs continue to remain a key concern for funds, with the author of the report, Alex Beath, finding that 75 per cent of that value added by funds is eaten by investment fees.

The net amount of value add on average is 15 basis points.

The study showed that if a fund was 100 per cent externally managed, and its investments were 100 per cent passively managed then it would need to be $10 billion before costs broke even.

Investment costs on average across the universe measured were 42.6 basis points. US funds had the highest investment costs by geography at 46.8 basis points, while Canadian funds were the lowest at 36.2 basis points.

The report looked to determine to what extent institutional investors added value above their benchmarks and aimed to deconstruct whether this was alpha or really beta in disguise.

Of the value added, around 65 per cent was due to beating the benchmark within asset classes, and about 35 per cent was due to tilting in the long or short term.

“There is some gamesmanship in this, as it depends on what benchmark is chosen,” Beath says.

In many instances the asset class determined whether the value added was beta or alpha.

“For example within fixed income investors on average produced “alpha” above the benchmark, but really they were overweighting credit to government debt. A lot of value added comes from what might be beta decisions not alpha and is dependent on the benchmark chosen.”

In other asset classes investors were making more active decisions such as geographic tilts or decisions like a mandate ex- Japan or parts of Europe. Then in other asset classes like REITs or small cap there are inefficiencies there were beta decisions that didn’t help them at all.

While the funds in the report varied greatly in their size, asset allocation, portfolio construction, the amount of indexing and the assets managed internally, all of which have an impact on their ability to add value.

Not surprisingly however the report made some clear findings with regard to size, active management, internal management.

CEM found that active management makes sense after costs, showing that if a fund was 100 per cent actively managed it would increase the net value added by 39 basis points relative to 100 per cent passively managed funds.

It also found that funds that are 100 per cent internally managed increase their net value added by 22 basis points relative to 100 per cent externally managed due to reduced investment management costs.

There is also a significant size effect, with funds increasing their net value added by 8 basis points for every 10 fold increase in assets, due to a decrease in investment management costs.

 

 

 

Governance of institutional investors and the lengthening investment chain causing  bigger distances between assets’ beneficial owners and those involved in executing investment strategies was one of three practical issues raised by the OECD general secretary as a barrier to more investment in long-term investing financing.

Speaking at the OECD Project on Institutional Investors and Long-term Investment roundtable, Gurria gave an update from the recent Brisbane G20 Leaders Summit as well as the future agenda for institutional investors and long-term investment in view of the future Turkish presidency of the G20.

In his speech, he said the G20/OECD High-Level Policy Principles on Long-Term Investment Financing by Institutional Investors provided a solid starting point for tackling the issues but there needed to be policy solutions to remove the obstacles to long term investing.

An extract of his speech is below:

“Following the guidance of G20 Leaders in Brisbane, we now need “to walk the extra-mile” and move “from solutions to actions”.

To this end, let me briefly address a few practical issues:
First, we need to address the issue of the governance of institutional investors. The lengthening ‘investment chain’, with bigger distances between assets’ beneficial owners and those involved in executing investment strategies, necessitates well-aligned incentives for every link in the chain.

We must remember that most of the money that circulates in this investment chain ultimately belongs to ordinary working people. Money they save for retirement or perhaps their children’s education. Similarly, those executing the investments also need to have the right skills and expertise to be able to expand their investment universe to alternative asset classes, in particular those that can support infrastructure investment and green projects.

Second, we need to address the question of financial regulation and its impact on the ability of institutional investors to provide financing for growth.

There is a need to balance stability and transparency against the need to ensure that institutional investors can act as proper financing channels for investment. For example, strict solvency rules, and related ‘mark to market’ accounting, may inadvertently put a brake on productive investment. More generally, governments need to ensure that the “conditions for investment” reduce legal and regulatory uncertainty.

Third, there is a clear need for more in-depth discussion on what are the most relevant and efficient financial instruments for long-term investment. We need to look at project financing needs across the entire life-cycle of investments to identify the optimal “division of labour” between different providers of finance.

“Pooling” mechanisms to get large and small institutions to participate in debt and equity financing can also play an important role. To facilitate these discussions, the OECD is developing a taxonomy of techniques, instruments and vehicles that policymakers can use to leverage private sector financing in infrastructure.

Ultimately, these three issues are just a sub-set of the much broader question as to what type of financial system we wish to construct. In advanced, emerging and developing economies alike, there is a need to enhance the role of fair and transparent capital markets. We need to consider concrete steps like the development of local currency bond markets; the issuance of project bonds; and the development of appropriate hedging instruments.

On these and many other issues, we are working together with the incoming Turkish presidency of the G20 on how best to advance the LTI agenda to promote stronger, fairer, greener growth.”

 

For the full speech click here