Smart Beta could provide a middle ground for DC schemes who want elements of active management but at a reasonable cost says Robert Holford, retirement lead and head of strategic consulting

This blog was brought to you by:

Spence Johnson

 

Over the past few years DC scheme investment designs have increasingly favoured passive funds to fulfil core default strategy allocations to single asset classes such as UK or Global Equities over more expensive actively managed funds. Driven largely by the need to reduce costs, the rapidity of this shift has begun to raise concerns about what outcomes purely passively implemented default designs might deliver if market conditions become more volatile in the future.

With its aim of delivering returns based on the same factors that have traditionally driven the performance of many actively managed funds at lower costs, many are beginning to ask the question as to whether the emerging ‘smart beta’ market represents an ideal middle ground for schemes looking to re-introduce some of the benefits of active management into their default strategies without significantly increasing their costs.

In UK DC, the adoption of passive approaches by the largest institutional schemes has been significant. As at the end of 2015 Spence Johnson estimates that just 8% of the £81bn invested in the default strategies of large ‘institutional’ DC schemes with more than 1000 members was invested in active “single asset” funds. By contrast passive funds account for an estimated 60% of the assets in these funds.

Active management has been challenged not just in terms of its cost, but also in terms of whether these costs can be justified by the long-term performance these funds have delivered. In a recent report S&P Dow Jones concluded that over the past decade 86% of active equity funds have underperformed their benchmarks. Balanced against this active managers have argued that passive investing leaves investors exposed to greater levels of volatility, as well as hidden concentration and systemic risks.

Whatever the conclusion schemes reach in this debate, in DC, with default member charges capped at a total of 75bps (which includes the cost of the pensions administration where this is passed on to the member), many schemes struggle to include traditional single asset active class strategies offered at 50-80bps (or higher) as one of their core DC default strategy components.

Over the past few years actively managed strategies, especially those focused on single asset classes, have, therefore, increasingly found themselves relegated to ‘satellite’ positions in default strategies. These satellite allocations are often in asset niche classes such as emerging markets or property where manager skill is perceived to add the greatest value or where passive substitutes are less readily available.

The emergence of smart beta strategies, however, is beginning to offer schemes increased options when looking for alternatives to the passive products that currently occupy the ‘core’ allocations with many DC defaults.

Smart beta funds employ rules-based investment approaches to systematically capture factors such as value, growth or momentum that have historically delivered above-market returns over the long-term. In addition more risk-focused smart beta approaches aim to offer better risk-adjusted returns to investors through volatility reduction and diversification. In this way smart beta seeks to deliver many of the underlying features of actively managed strategies but with greater transparency and lower costs than traditional active funds.

It is these latter characteristics that are most appealing in a DC context. With risk-focused/managed volatility and factor-based alternative index funds all currently being offered for prices that range between 25 and 35 bps, smart beta approaches can clearly fit within the charge-cap constraints as core default fund components. In addition smart beta strategies are suitable for a range of roles across the entire lifecycle of default strategy designs. For example return-focused strategies fit well into the more information-ratio-oriented growth phase while managed volatility approaches fit nicely into the de-risking phase, where investing tends to be more focused on maximising sharpe ratios.

Although at present Spence Johnson’s research suggests only 1% of ‘institutional’ DC schemes’ equity assets are allocated to smart beta, over the next ten years this is predicted to rise to over 10% of equity portfolios. In addition, with overall passive equity assets expected to grow to nearly £300bn over the same time period, a clear opportunity is emerging for smart beta products that can convince DC schemes to engage in even more significant moves away from purely passively implemented default strategies.

Robert Holford is retirement lead and head of strategic consulting at Spence Johnson

Spence Johnson