The common view is smart beta is used to side step expensive active equity managers or hedge fund managers whose processes are on the surface opaque, but on close investigation turn out to be largely beta like in approach.

As investors have gained experience and familiarity they have also learnt about how it offers greater granularity of approach, by offering investors access to different kinds of risk premia many of which can be used in a tactical way.

The A$53 billion Sydney-based First State Super has used smart beta to get exposure to particular risk factors that were attractive at a point in the investment cycle or to manage exposure to a particular asset class or sector where the fund might want exposure or to avoid an exposure.

Michael Blayney, head of investment strategy at First State Super, says there is a whole skill set in combining factors. He cites the example of how combining a quality portfolio and a value portfolio might produce a sub-optimal outcome, compared to buying the value portfolio with a quality filter because the factors can combine in a nonlinear way.

“There are so many different risk premiums you can extract, extracting just one in a very simplistic way is probably not going to be the optimal way to do it,” he says. “If however you are looking to do something which perhaps complements the rest of your portfolio, then it can make a lot more sense depending on what resources you have, either partnering with an asset manager to build it in-house yourself,” he says.

The timing of an investor’s entry into a factor needs to be considered.

“You can look at whether a portfolio of stocks trades at a premium or a discount compared to how it trades relative to the market through history,” he says. “So you can get a feel for whether you are overpaying for something that’s popular or not.”

On this point, Blayney seeks to make a distinction between the times an investor would use a tailored smart beta portfolio and when it would not.

“If you just want a short term tilt on value, then picking an off the shelf index and implementing that makes a lot of sense,” he says.

So after implementing such smart beta strategies what does success look like for an investment team? Certainly this is the case if a smart beta portfolio gives the same return as the index with a much smoother journey revealing itself to have a superior sharp ratio. However, other factors may naturally come with a higher volatility than the index and here an investor would need higher compensation than what the index returns. Other benchmarks of success might be outperforming in down markets or simply delivering better diversification.

Measuring this outperformance is problematic because a risk premium can take 10 years to manifest itself and be observable. “These things can underperform for a long period of time,” warns Blayney.

This all hints at how hard it can be to explain the decision making process of smart beta compared to say, a fundamental equity manager.

“[To explain how a fundamental equity manager works is] very easy and very intuitive. You can talk about the companies and their earnings,” he says. “But when you go and try to explain a smart beta strategy to somebody, you start talking to them in terms of risk premia and factor exposures. It is actually far more difficult to communicate that.”

The A$33 billion Sunsuper is another investor with experience of smart beta or factor investing as it prefers to call it. It has used the style to overcome a large factor bias in certain indices, as a means of reducing fund management costs where it has lost faith in active management but not in a particular factor.

For Joshua Bloom, portfolio manager for international shares at Sunsuper, timing is key in entering a factor in terms of its price.

For Bloom, this places a large emphasis on the decision of the investor to make the decision to allocate – poor performance could not be blamed on a lack of skill by the manager.

“If you’re the one that’s selected a factor or premium that for whatever reason is not working, it’s not the manager’s fault anymore,” he says. “Whereas now the decision is solely the asset owners or the board or whoever is making the decision.”

 

This article are taken from a round table discussion hosted by conexust1f.flywheelstaging.com’s sister publication, Investment Magazine, on smart beta undertaken by Australian investors, consultants and Goldman Sachs Asset Management.

The London Pension Fund Authority (LPFA) and the Lancashire County Pension Fund (LCPF) have agreed to a liability asset management partnership – known as the Lancashire and London Pensions Partnership (LLPP) – that allows for the pooling of assets and a reduction in investment costs.

Each of the funds will retain their own strategic asset allocation, but assets will be pooled and managed by a new regulated investment management company that will provide services to both funds. Investments will be managed both internally and outsourced to fund manager providers.

Further, the new organisation which will manage the funds combined assets of £10.4 billion will be set up such that it will be made available to other funds

There are other UK funds – USS is one obvious example – that have created investment companies that are at arm’s length from the trustee. But Chris Rule, chief investment officer of LPFA, says this goes one step further than many private sector peers as the organisation will be set up so it can manage money for third party funds in the future.

“The number one priority is getting this working for London and Lancashire. But we are very cognisant of interest from other prospective partners and our longer-term plan is to scale this up to about £30 to 40 billion,” he says.

The obvious benefits to both funds of pooling assets include cost savings from economies of scale, negotiating power with funds managers, and also the ability to bring investments in house.

According to David Blake, professor of pension economics at the Cass Business School, the average size local authority fund in the UK is £2.3 billion but there is a huge disparity in the amount spent on investment costs. In 2014/15 the LPFA spent around £31 million on fees, but some local authority funds have spent a lot more.

“This pooling of assets will drive economies of scale in a number of ways,” Rule says. “There is the straight forward fee. We are allocating more money so we will get a better deal with service providers. We will also be able to manage more money in house, which will present savings. And with greater assets under management we are able to allocate meaningful amounts to assets such as infrastructure where you need to have big equity tickets to influence the asset. The larger AUM will allow large investments while maintaining appropriate diversification.”

A conservative estimate is that pooling of assets will save £32 million over the next five years across the two funds.

“The envisaged savings are based on some straight forward assumptions and we believe we are being conservative. We have spoken to managers and asked for revised fee proposals, and we’ll also realise some savings from managing a portion of the assets internally. We have offset that savings against the transitional costs as well asome permanent incremental costs, such as the increase in investment professionals, and overall we think we’ll save £32 million, and that’s straight to the bottom line.”

Each of the funds will maintain their own asset allocation and strategy and then allocate down to various pools run by the new company. The underlying pools will have varying investment mandates, some will be managed internally and some externally.

The LPFA has around 34 fund manager relationships, most of which are in private markets.

The LPFA now has about £600 million in equities managed internally, which is about 12.5 per cent of assets.

“We are at the early stages for internal management at LPFA. Over the longer term I would expect significantly more managed internally,” Rule says. “I expect LLPP to continue along this path and would be surprised if we did not have at least 20 per cent managed internally relatively quickly, longer term this could be significantly higher.”

The new organisation, which is still to get regulatory approval, will combine both the investment teams of LPFA and Lancashire, and Rule says there are significant plans to expand the number of investment professionals beyond the combined team of 14.

As the breadth and skills of the internal teams increases the proportion of assets managed internally will also increase. However, internal management needs to meet the same tough standards that are expected of external managers.

“We need to look at net and gross performance,” he says. “There is no point reducing fees and managing more in house if your gross performance goes down.”

While Rule says that pooling assets is a reason to reflect on the asset allocation, and indeed there is currently an internal review under way, he does not expect any dramatic changes to asset allocation.

LLPP will, however, focus on defining and articulating the common investment pools that will be the investment building blocks. This will allow for better communication to the regulator and also potential partners.

“We want to demonstrate this as a model for collaboration, it is important we set it up in a way that works for other schemes. This may be working in a holistic way, as is the case for LPFA and LCPF or in a single asset class.”

LPFA already has a separate jointly owned investment vehicle for infrastructure with the Greater Manchester fund, and Rule says there have been specific enquiries from other investors in some other asset classes, particularly private assets.

The new investment organisation will be a full pension services organisation, providing both investment and pension administration services to the two local authority funds, as well as risk management both in investments and covenant risk. It is currently preparing the regulatory submissions for the operating investment company and the various fund vehicles with a target “go live” date of April 2016.

There is a huge diversity in pension system design across the globe, reflecting historical, cultural and institutional diversity. There is much to be learned by each of the different systems, so in order to compare the benefits of various systems, two authors from APG in the Netherlands postulate a new classification of four role models of funded pension plans.

They thus provide an in-depth comparison of funded pension savings plans around the world.

The research by Eduard Ponds and Manuel Garcia-Huitron, funded by NETSPAR, proposes new classifications based on choice architecture and type of regulation, and the authors illustrate the features of each role model with 12 representative pension plan case studies from 11 countries.

“Valuable lessons can be learned from international best practices, but we avoid making any normative comparison,” the authors say.

The authors come up with four models: the centralised choice model, the delegated choice model, the regulated choice model, and the induced choice model.

They provide examples of various plans from different parts of the world and a matrix of positive and negative attributes for each category.

While they acknowledge “the search for an optimal pension system may be a futile exercise as each model has strong institutional and historical roots that are deeply wired into cultural attitudes towards freedom of choice, flexibility and the role of (and trust in) the state and the private sector,” the authors believe there are valuable lessons to be learned from the international experience.

 

The paper can be accessed below

Worldwide diversity in funded pension plans – four role models on choice and participation

 

 

The growing interest in low-volatility equity products is of course increasing supply. It should come as no surprise that products with (virtually) the same description may be different. What to watch out for when selecting low-volatility products? Read the full article.

In this paper, Ashby Monk and Rajiv Sharma from the Global Projects Center at Stanford University, examine the balance of power among the various parties in the private assets investment food chain. They argue that fund managers have too much power, as do the consultants that act as gatekeepers to those managers.

While the authors recognise managers add a certain amount of value to the investment process, they argue that there is scope for investors to improve the situation by exercising their bargaining power.

They propose the “relational contracting concept” as a more aligned governance arrangement for investors and investment managers.

On a practical level, this would mean redefining the terms and conditions of the agreement to include more openness and collaboration between the investor and the manager.

It could mean increasing the time horizon of the funds, or making them open-ended with the ability to withdraw capital under certain rules or conditions.

“A fee structure that provides discretion to the investor for rewarding or punishing managers would be preferable. Placing emphasis on a robust termination clause as opposed to paying expensive carry incentives may help to achieve more alignment,” the paper says.

 

To access the paper click below

Re-intermediating investment management

 

Are all value stocks and all momentum stocks equally attractive? In our research, we found that different types of value and momentum stocks exhibit very different performance characteristics. A value approach which incorporates some momentum and risk considerations tends to outperform a generic approach, but a value approach which intentionally goes against these factors significantly underperforms. Our analysis helps to better understand what differentiates a successful factor investing approach from an unsuccessful one. The return difference between good and bad strategies can be up to 5-7% per year. Read more about this research.