With the advent of smart beta it was only a matter of time before the appropriate use of “smart” was analysed and questioned. A paper to be published in the forthcoming summer 2014 issue of The Journal of Portfolio Management looks at the active choices of smart beta strategies and how and when they can be labelled “smart”.

 

In the abstract the paper’s authors, Bruce Jacobs and Kenneth Levy say:

Smart beta strategies aim to outperform the capitalization-weighted market through relatively simple alternative weighting methods that emphasize a handful of factors such as size, value, momentum, or low volatility.

Because of their simplicity, smart beta strategies bear a resemblance to passive investments. Yet, smart beta strategies are the product of active choices and can be compared with active multi-factor strategies (“smart alpha”).

When considering any active strategy, investors should have a clear understanding of the sources of expected returns, the stability and sustainability of those returns, the risk exposures and risk controls, the liquidity demands of the strategy, and whether the management costs are commensurate with expected results.

Only then can investors determine which strategies are deserving of the “smart” label.

 To access the paper by Bruce I. Jacobs and Kenneth N. Levy, click here

 

 

US public pension funds are ignoring their liabilities in managing their pension assets, a situation that needs a paradigm shift in thinking and asset allocation to ensure benefits can be paid to beneficiaries.

The dialogue about the US public pension funds’ underfunding position continued at the CFA Institute’s annual conference this week, with Ronald Ryan calling for pension funds to tell the “financial truth”.

Ryan, who is chief executive and founder at Ryan ALM, Inc., which specialises in custom liability indices and liability beta portfolios, says the accounting rules governing US corporate and public funds are distorting the real underfunding position, which is much worse than reported.

Further, he says pension funds tend not to manage to liabilities, a situation which means “you don’t know the enemy”.

“Given the enormity of the pension crisis, investment consultants and those managing the pension assets need to say what we have been doing doesn’t work. It’s simple – tell the financial truth,” he says. “Imagine a doctor getting an X-ray or blood test wrong, well that’s what’s happening in pensions, it’s getting the wrong diagnosis. Without a customised liability index you don‘t know the enemy, you don’t know what liabilities look like. But they are big and they are very interest rate sensitive.”

Ryan says there needs to be a paradigm shift in the asset allocation of the US pension system so that liabilities can be funded in a stable and low cost way.

He advocates for each fund to have a custom-liability index, which sets out the benefit schedule which can be priced at market rates and the size, shape, duration and interest rate sensitivity of liabilities can be managed.

“At every investment meeting of a pension fund you would think there would be a discussion of the funded ratio to gauge if they are on track and how to make sure the asset allocation responsive to liabilities. But this doesn’t happen,” he says.

Ryan, who was also formerly director of fixed-income research at Lehman Brothers and has received a number of awards, including the Bernstein Fabozzi/Jacobs Levy outstanding article award from the Journal of Portfolio Management and the William F. Sharpe Indexing Achievement Award for lifetime achievement from the Information Management Network, also advocates for a change in the language around pension management.

“Once liabilities are defined as the true objective, we have to redefine the language used. For example alpha will no longer be excess asset growth, but the amount above liabilities growth.”

One of the problems he identifies is that change will involve the players in the industry recognising they got it wrong.

“Consultants find it hard to say all these years we’ve been doing it wrong and now I want to do it differently,” he says.

 

The evolution of the $43 billion QSuper’s offer to all members is definitely not at an end.

In fact, Rosemary Vilgan, chief executive of QSuper, sitting in the board room of QSuper’s on the top floor of its Brisbane office, archly states: “I keep saying to people you should not work here if you do not like change.”

The continued innovation is driven by the events of 2008 when some members saw their account balances drop by 30 per cent  – an arguably more traumatic, or atleast dramatic, event for QSuper than other funds.

Higher than average member balances, around $140,000 currently, means QSuper members lost more, its members having built up contributions long before most other plans came into existence in  Australia in 1993. QSuper celebrated its 100th birthday in 2013.

The GFC forced some to delay their retirement and QSuper staff were on the end of a certain amount of bitterness and awkward conversations, a moment etched in Vilgan’s memory. So much so, that she riles at those who look sunnily on the return to more healthy investment markets of late.

“That is the thing that is making me angriest at the moment is when you hear the popular media say it is great, we are out of the GFC, long term returns are back.  Real people actually experienced that dip.”

QSuper has rejigged its members, and subsequent investments, into eight cohorts with different levels of investment risk, which come into effect this month, but will evolve as the fund gathers more information about its members.

The groupings of members are currently based on what data the fund already has on file; their age, account balances and salaries. As the fund learns more about its members’ personal wealth and planned retirement dates then more groupings may emerge.

In theory, QSuper would like to offer tailored solutions for all its 500,000 members in the manner of the theory espoused by Professor Robert Merton through the firm Dimensional Fund Advisors, but says it is impractical to employ for 500,000 people. Vilgan says she admires Merton’s ideas and muses that it could be put into the “suite” of member options.

In the meantime, the eight cohorts will be updated and adjusted in reaction to changes in the cost of living for pensioners, the age pension, Centrelink benefits, interest rates and the prices of staple items.

“People with lower investment balances got a lot out of Centrelink. So if budget changes Centrelink benefits we will change calculations,” says Vilgan, who along with chief investment officer Brad Holzberger shares the distaste with the fascination some hold with funds’ asset allocation decisions, believing such cost of living measures are often neglected.

A new retirement income product

While these changes are in train, QSuper is already thinking further ahead by exploring how to build new retirement products, particularly in those that pay out if a member lives until 80 or beyond.

One idea that appeals to Vilgan is a form of long life insurance for which members pay a premium from age 50 onwards. This would build up an investment that might be held in CPI linked infrastructure –  at the very least it would be less conservatively invested than an annuity.

Unlike an annuity, the eventual payout would be a lot freer from the vagaries of markets on the day it was paid out. In this model members would live off savings and Centrelink benefits between the ages of 65-80, before receiving their payment.

“One of the advantages is that you know how long that money has to last,” says Vilgan who believes members probably underspend to budget for the eventuality of living beyond 80.

The product she proposes would pool investments and would pay back a member’s estate if they died before 80, a sum equal to their contributions. If they live long enough to draw on it they would get the pooled investment returns that have accrued.

Part of the reason for the interest in such products is the aversion many savers have, in particular QSuper members, to purchasing annuities.

“One of the biggest downfalls in normal annuity purchase is giving up $50,000 in one hit and the fear of not living long enough to get that money back,” says Vilgan.

The take up of the white-labelled Challenger lifetime annuities has been “very quiet” admits Vilgan, who does not state a figure of purchases, but says it is less than 100 and at best in the 10s. It has not been an ideal time to purchase as market conditions have led to falling annuity rates, though she thinks members behaviours need to change too.

“We probably need to think of ways to guide members to a deferred annuity or a pooled product into income stream accounts.” She muses on whether part of the projected 12 per cent contribution into super could be allocated towards an income bearing product in retirement.

A super insurer?

In the above model of a long life ‘insurance’, a fund is not taking any balance sheet risk due to the lack of a guarantee, so it would not need an insurance licence, but Vilgan sees no reasons why a fund or a collection of funds could not do that.

“Super funds are now big enough institutions that either singly or collectively, some of us might get life insurance licences,” she says. “It has certainly been put out there in the industry, that if we want some of these products why wouldn’t we use a collective to organise them. There are a few funds who are saying ‘how can we create retirement?’ and ‘what moves are we prepared to make?’.”

She cites the example of the ME Bank as one such a model, but also describes the giant US teachers retirement fund TIAA CREF as “inspirational”, for being a defined contribution accumulation plan which also holds an insurance licence for issuing lifetime and deferred annuities.

One of the reasons QSuper is so gung-ho on change is that it controls its own administration, but this is not true of many other big funds who are often struggling with the cost or the limitations of their administrator.

“We have had some of those funds talk to us, they want to innovate as we are doing, but you have to administer it,” she says.

QSuper’s thinking extends to a belief that as much uncertainty and volatility on retirement income should be stripped out as possible. And that they more important than a skewed focus on achieving industry beating returns.

“You should really be measured on what fund got me to a more predictable outcome, not on which fund outperformed on a particular year,” she says.  “Funds will definitely move down that path, which will definitely mean ratings agencies will have to change how we are measured.”

This is a popular theme of Vilgan’s who is convinced members instinctively distrust the volatility inherent in defined contribution plans currently and would settle for a loss of some upside if they could have more predictable returns. Indeed, a tiny proportion of members (around 0.5 per cent) that have opted out of the eight cohort strategies created for them this month, has given her greater confidence to move in this direction.

“Huge numbers actually say you are the expert, I trust you. It is really quite interesting that this industry has not taken on that mantle more. You should not underestimate the number of people for whom this is such a complicated world. That they are relying on us to do a job and they do not enquire into the detail. We have underestimated how much people think are doing the best by them. If this industry was doing the perfect job, you would not have to worry about your account, you would just know there was an income waiting for you in retirement.”

 

 

Australian fund, QSuper’s creation of eight different investment cohorts for its 440,000 default fund members this month has sparked curiosity and admiration from defined contribution experts in the US, the UK and New Zealand.

The investment strategies for each group will be focussed on an estimated retirement outcome for that segment, taking into account the median projected retirement income including age pension entitlements, salary and contribution rates and retirement date.

Rosemary Vilgan, chief executive of QSuper, said the rise in contributions from 3 per cent to 9.25 per cent and the impact of the GFC presented an obligation to adapt and that QSuper’s move would pose a challenge for other Australian super funds to change too.

 

Federal Retirement Thrift Investment Board, Washington D.C. USA

Kim Weaver, director, external affairs for the Federal Retirement Thrift Investment Board, which manages US $358 billion for close to five million Americans, described QSuper’s developments as interesting, not least because the Thrift Savings Plan kept an eye out for ideas used overseas that they could draw upon.

The Thrift Savings Plan offers five lifecycle funds that are custom designed to take the same factors being used by QSuper into account, she said.

“Our L Funds are reviewed annually and updated demographic information is taken into account, along with other market factors. The L Funds’ asset allocation is updated as appropriate.”

 

Mercer, Leeds, England

In the UK, one of largest advisors of corporate plans is seeing a trend towards multiple lifecycle funds.

Paul Macro, UK DC & savings client leader at Mercer, said he knew of a few plans that offered three lifestyle strategies and following recent budget changes which have ended compulsory annuitisation more would follow.

“There has been lots of talk about having multiple default options and to do this, recognition of the types of members that are in the scheme will be necessary.”

He added: “I suspect many trustees will be nervous of making different assumptions for different people – but that as the experience of member behaviour in the ‘new world’ develops over time, this may change.”

 

NZ Superfund, Auckland, New Zealand

David Iverson, head of asset allocation at NZ Super saw the move as logical but was worried about the communication challenge.

“Even though the approach is a step in the right direction, it has the potential to not be seen that way,” he said. “In other words, individuals may not know how to articulate an investment plan that matches what they need/want. But they do know how to compare – with cash, with other funds, with other options. While this behaviour already exists, it can become heightened if a provider is doing something different, and may not be well understood.”

 

Professor Robert Merton, MIT Sloan School of Management, Cambridge, Massachusetts, USA (also resident scientist at Dimensional Fund Advisors Holdings Inc.

“Like Dimensional’s Managed DC, QSuper understands that the goal for superannuation should be providing retirement income and they’ve made a great start on framing it in terms of the needs of the individual member.

“The solution we’ve developed at Dimensional, though, goes further than just two factors in terms of personalisation of the investment process. In addition to age and existing account balance, Dimensional includes other important factors such as current salary, contribution rates, gender and time to retirement.

“Obviously, the system needs a well-designed default strategy to be effective for the majority of people who do not engage with super.”

 

 

 

 

If Robert Litterman were a CIO of a public pension plan he would not try to hit an “unrealistic return target”. Amanda White speaks to him about risk, quants, asset allocation and climate change.

There is a serious problem with US public pension funds and the “unrealistic commitments and unrealistic return targets” they have set, says Robert Litterman, co-developer of the Black-Litterman Global Asset Allocation model and risk expert.

“If I were the chief investment officer of a public pension fund I would definitely not increase risk to reach unrealistic return targets.”

The responsibility, he says, is with the entities backing up these promises to recognise there will be significant shortfalls in funding pension benefit promises, but the implications of that have not been acknowledged.

He says chief investment officers managing those assets should not try to hit unrealistic return targets, rather they should understand their risk parameters.

“It is not realistic that equities performance will bail you out,” he says.

Litterman acknowledges there have been advancements in portfolio management over recent years and that investors have been more sophisticated in thinking about their portfolios.

Most notably, he says there is a recognition that risk is a multi-faceted and a multi-dimensional problem. He uses liquidity as an example, noting portfolios are regularly stress tested for liquidity, something that was rarely modelled 10 years ago.

“There is not one source of risk premium,” he says, and timing those different risks makes sense as an opportunity for adding value to a portfolio.

However Litterman says those risk factors need to be actively managed, and he doesn’t believe in a passive exposures to a set of risk factors.

“On average people are holding the market then if you tilt to smart beta someone has to be tilted away,” he says. “Interest rates are an example: quantitative easing is artificially holding down interest rates, so it would make sense to have less than average exposure to interest rates but not everyone can do that – timing different risks makes sense.”

Litterman agrees with the notion there is a spectrum of risk premia with free, unlimited and available market beta at one end, and alpha at the other, and that investors should dynamically allocate to these factors.

Alpha, he says, involves skill, it is not readily known, requires execution capabilities and is usually short run.

“Alpha doesn’t sit around waiting,” he says.

The range of risk premia in the middle is a constant evolution, he says, pointing to the “value factor” as an example.

“The value factor in equities was alpha but now it is so well known and easy to do it’s not alpha, and the risks are greater because of the flows in and out so there has also been a risk/return deterioration.”

One of Litterman’s latest interests is climate risks and he’s a board member of the asset owners disclosure project, attacking climate change from a risk management perspective.

It’s good news for the market, business and society in general. As soon as a quantitative risk manager is involved the prospect of a price for carbon is a whole lot more realistic.

“This is an asset pricing problem. There is tremendous uncertainty and it requires pricing immediately. The reality of climate risk has penetrated to the point there’s little informed discussion but it is starting to sink in, so now what do we do?” he says. “Many people think it’s an ethical issue, ethics and morality doesn’t tell you the right price, science and risk management does,” he says, adding that somewhere between $40 and $60 is about the right price.

Litterman, who is a partner at Kepos Capital and was for many years the head of the quantitative investment strategies group and the global investment strategies group at Goldman Sachs, has spent much of his career around quantitative modelling (he is now also executive editor of the Financial Analysts Journal).

He admits that the returns in the quant movement as a whole was more to do with inflows of assets than fair pricing, but thinks that now quants “are a bit out of fashion, it could be a good place to be”.

His experience is that markets are becoming more efficient over time and with this in mind investors should set a strategic benchmark portfolio and then decide how to manage assets around that.

“If you think you can add value by tactical asset allocation decisions then it’s an avenue for adding value. It is very difficult to do, because markets are pretty darn efficient, but it does provide an opportunity,” he says. “It is hard to be more accurate than the aggregate market view but sometimes things happen like investors over react. It is hard though, and anyone who says it’s easy is probably looking backwards.”

What is possibly a greater consideration for large institutional investors, Litterman says, is the issue of rebalancing a strategic allocation.

“Should the strategic asset allocation be fixed over time? It’s not an equilibrium, not everyone can sell. In deciding to make an active decision to rebalance then you could be being contrarian to the average investor,” he says. “One is not better than the other but it’s important to understand which side you’re on and why.”

It’s a concept that Litterman discussed with Bill Sharpe on stage at the CFA Institute Conference in Seattle this week, on the back of Sharpe’s 2010 paper “Adaptive asset allocation”.

The article proposes an asset allocation policy that adapts to market movements by taking into account changes in the outstanding market values of major asset classes., and avoids contrarian behaviour.

 

 

 

Defined contribution plans focus too much on the short-term accumulation of pension assets rather than the longer-term goal of securing an adequate retirement income.

This paper by the World Bank, based on case studies from a number of countries, argues that pension supervisors have not properly defined the objectives of DC pension systems

It suggests that in order to have a meaningful impact on future pensions, the supervision of DC systems needs to take a more proactive role in minimising pension risk.

This objective would require ensuring that investment risks are aligned with the probability of achieving a target pension at retirement age.

 

To access the paper click below

Pension risk and risk-based supervision in DC pension funds