Index construction is pushing the boundaries of active management, with index providers launching products such as high beta to take advantage of market movements.

S&P Indices is the latest to add to its family of high-beta indexes, recently launching two indexes of developed and emerging markets.

Alka Banerjee, S&P Indices’ vice president of strategy and global equity indices, says index construction is pushing into areas of strategy that have previously been the domain of active managers.

S&P, along with other index providers, has been moving aggressively in recent years into what it describes as “strategy indexes”.

“There is definitely a lot of innovation in the indexing world, moving into things that have been in the domain of active managers so far, of trying to extract value other than market value by developing new strategies,” she explains.

“We find, if we have clear, transparent and easy-to-understand rules that can be implemented in a consistent and regular manner, over time those strategies can be indexed and it is a huge cost advantage to the investor.”

In S&P research conducted last year that tracked the performance of alternative beta strategies researchers found that some strategies had outperformed compared to active management.

The report Evaluating Alternative Beta Strategies by Xiaowei Kang, S&P’s index research and design director, finds that over a 10-year period from 2001 to 2011, simple equally weighted and low-volatility strategies significantly outperformed the S&P 500.

Specific objectives

By comparison, the average US large-cap manager has lagged behind the S&P 500 over the same period.

Kang finds that although alternative beta strategies aim to achieve better risk-adjusted performance than cap-weighted portfolios, they are often constructed with more specific objectives in mind.

“These objectives include achieving a systematic value tilt, lowering portfolio volatility or reducing stock-specific risks, and may define the essence and main applications of different strategies,” the report finds.

In an indication that investors are increasingly looking to hedge for a market upswing, S&P Indices’ latest additions to its high beta family of indexes cover stocks in both developed and emerging markets.

The indexes measure the performance of 200 stocks in their respective markets that are most sensitive to changes in market returns.

The most sensitive stocks receive the highest weights. The indexes: The S&P BMI International Developed High Beta Index and the S&P BMI Emerging Market High Beta Index have been licensed to a third party which plans to launch exchange-traded funds based on them.

“Of course, you have your basic market beta investment, but then you have allocation to high beta and an allocation to low volatility and you cover yourself for both bull and bear market scenarios so you are not completely at the mercy of the markets,” Banerjee says.

The developed market index tracks the 200 most market-sensitive stocks within the S&P Ex US-Korea LargeMidCap Index. Countries it covers include Canada in North America, Germany, France, Ireland and Italy in Europe and Australia, Japan and New Zealand in the Pacific, and Israel.

The emerging market index covers stocks in Eastern Europe, Russia and Turkey as well as countries throughout Asia, Latin America, the Middle East and Europe.

It is possible for the best elements of defined benefit (DB) schemes to be applied to defined contribution (DC) schemes, by replicating real deferred annuities to produce superior pension outcomes for members, according to a new paper by APG.

The paper, How to mimic DB-like benefits in a DC product, does what it says.

It demonstrates through simulation that by using derivatives there is a way to combine the best of both worlds into an individual pension product that has clearly defined ownership  while delivering a DB-like pension.

In the paper, its author, APG-intern Jens van Egmond, says while there is a clear global trend towards defined contribution, the solution is sub-optimal because of the disconnect between the accumulation and decumulation phases of the schemes.

“Defined benefit is a fully integrated product,” van Egmond says. “Defined contribution is a pension savings scheme, a wealth management strategy. It doesn’t tell you what you can do with that money at retirement.”

Van Egmond says the study rests on the premise that people want income over  their whole life.

“A real annuity is the best way to achieve that, and you can only get that in a defined benefit scheme,” he says.

Stefan Lundbergh, one of van Egmond’s supervisors and head of the innovation centre at APG, says defined contribution funds are essentially wealth management or active management solutions.

“That makes it easy to communicate that your wealth is growing,” Lundbergh says.

“A real pension solution delivers future cash flows, of which the net present value is much more volatile than just wealth accumulation. That’s a very difficult thing to communicate.”

Because defined contribution funds don’t have a pension payout mechanism, the member is subject to “conversion” risk when converting the pension wealth into an annuity at retirement.

The paper proposes a solution where interest rate and inflation derivatives protect the purchasing power of the defined contribution investment over time, making the conversion risk a non-factor.

Essentially, the paper describes a way to match long-term future benefits with investments now.

Van Egmond describes it as using a traditional lifecycle solution, with an allocation consisting of a safe and a risky asset. But instead of using bonds as the safe asset, an asset mix replicating a real deferred annuity is used.

“You know the price of the annuity will change as interest rates and expected inflation vary.,” he says.

“When you invest into the safe asset, the investment amount is translated into future real monthly pension payments, or at least into a very close approximation of these cash flows. The safe asset can be converted into a real annuity at retirement day since it uses an investment strategy that moves the same way as the real deferred annuity moves when market variables change.”

Van Egmond says that replicating a real deferred annuity is dependent on three factors: the interest rate; the inflation rate; and mortality rates. It uses financial instruments to hedge the first two, while explicitly saving more to pay for longevity increases.

Interest rate swaps are used to hedge inflation. The hedging model uses an insurance mindset, and moves away from the asset management mindset of hedging by looking for correlations with certain asset classes. The break-even inflation quoted for inflation swaps is identified as the inflation measure. This provides a cost-efficient hedging method, but it relies on liquidity in the inflation derivative market.

Lundbergh says that while APG is not necessarily producing a solution from this research, it is committed to a different way of looking at the pension payout problem in DC funds.

“There is a gap in the market between standard defined benefit and the more traditional defined contribution models,” he says.

“In the long run, it would be great to have a hybrid product that combines the best from DB and DC for those who only have access to the current DC models. As a mission-driven organisation we are going back to our roots when looking at this problem.”

Ruben Laros, another APG supervisor, says Netspar, the national network of pension practitioners and pension scientists, offers a master’s degree in the economics of finance of aging. Part of this degree is an internship at one of Netspar’s partners, such as APG.

APG has offered more than 30 students the opportunity to do in-depth research into pension related topics. Jens van Egmond is the most recent graduate.

Towers Watson’s negative outlook for bonds and its advice to increase allocations to high quality credit is being reflected in portfolio shifts by institutional investors. (more…)

Source: EPFR Global.

This MSCI research note looks at the historical behaviour of two risk-based investment strategies and investigates their potential application in an institutional equity portfolio.

 

Does risk-based strategy diversification work?

The Securities and Exchange Commission should reinstate the investor advisory committee it abandoned in 2010 as part of a wider commitment to address near-term financial market reform, a group of institutional investors from across the globe have stated.

The investors, who represent combined assets of $1.6 trillion, wrote to SEC chairman Mary Schaprio calling for the SEC to address “unfinished business that is critical to protecting and strengthening shareowner rights and investor confidence in the financial markets.

Led by CalPERS’ chief executive, Anne Stausboll, the investors called for six initiatives including reviving the SEC investor advisory committee.

That committee, which was formed in June 2009 and abandoned in November 2010, was tasked with advising the SEC on investors’ concerns in the securities markets; provide the Commission with investors’ perspectives on current non-enforcement regulatory issues; and serve as a source of information and recommendation to the Commission regarding its regulatory programs from the point of view of investors.

(more…)