Passive investing is moving beyond the plain old tracker fund. Maggie Williams reports
Choose good value for money. Choose liquidity. Choose low volatility. Choose diversification. Growth. Transparency. Good member outcomes… Choose a default fund investment strategy that delivers the above for less than 0.75%.
Defined contribution default funds play a central role in shaping the retirement plans of almost all scheme members. But the investment industry has been set the challenge of delivering credible results against a sizeable list of requirements.
Access to increasingly varied indices as a basis for passive funds, as well as strategies for combining those funds into defaults, are starting to shake up DC investment and offer solutions that go far beyond the traditional passive model of tracking a mainstream market capitalisation index. Enter Passive 2.0.
There are strategies that make use of sophisticated portfolio construction techniques, but keep the costs down
“Passive investing tends to be perceived as really basic,” says Emma Douglas, head of DC solutions at Legal & General Investment Management (LGIM). “However, there are strategies that make use of sophisticated portfolio construction techniques, but keep the costs down by using index-based building blocks.”
Claire Finn, head of UK DC investments at BlackRock, believes that contract- and trust-based schemes take different approaches to default strategies.
In the contract-based market, she says “cost is first and foremost”, driven in part by the sizeable proportion of the charge cap allocated to administration.
She adds that the approach within contract-based funds is still typically focused around a 50/50 global/UK equities allocation in the growth phase, mostly using market cap-weighted indices. “It’s an ultra-cheap approach and we haven’t seen a lot of development in terms of defaults from a beta perspective.”
There’s still a heavy emphasis on cost, but trustees are more engaged with which investments will deliver best returns
In contrast, Finn says that the trust-based landscape has been more focused on value for money. “There’s still a heavy emphasis on cost, but trustees are more engaged with which investments will deliver best returns for members.”
A more considered approach to risk-taking, using techniques such as currency hedging, also characterises trust-based schemes, she says.
That emphasis on value for money has paved the way for greater adoption of passive investment, and more innovation in the market. “The use of passive, or indexed, investment is rising,” says Mark Fawcett, chief investment officer at mastertrust NEST. “The range of indices to track is also increasing significantly with the evolution of so-called smart beta.”
Fawcett adds that NEST prefers the term ‘alternative indexing’ to ‘smart beta’: “It’s a more accurate and less loaded term.”
Like Fawcett, Douglas points to the range of factors that can now be tracked as an important development. “We are seeing more interest in alternatively-weighted indices, such as low volatility, quality, value and size. All these market factors can be built into index investing. You are getting the added value of a more active tilt, but it’s still an index fund and so relatively low cost.”
The fund reduces exposure to companies with worse than average carbon emissions
LGIM’s recently launched Future World Fund has added climate-related factors as a further differentiator. Douglas explains: “The fund reduces exposure to companies with worse than average carbon emissions or fossil fuels assets. We also then look at increased exposure to those that are generating green revenue. That gives a climate balanced index.”
She adds that, as an investment manager which takes an active role in voting on behalf of its members, LGIM is in the unusual position of being able to reduce exposure to or disinvest from companies that are not responding to its climate change messages.
Douglas is clear that the fund can also generate credible returns: “It can’t just be about tree-hugging.”
HSBC has been the first pension fund to adopt the Future World Fund as its default strategy and Douglas says other announcements are in the pipeline.
Focusing on an outcome-oriented approach, rather than a more traditional index-tracking approach, is also a trend, says Manuela Sperandeo, EMEA head of ishares specialist sales at BlackRock.
Full visibility of holdings, and strategies that can enhance returns are particularly important
She adds: “There are also other characteristics of an outcome-oriented approach that are really relevant for DC. Full visibility of holdings, and strategies that can enhance returns are particularly important in the accumulation phase.”
She also points to use of minimum volatility or lower-risk tilts as important in the pre- as well as the increasingly relevant post-retirement phase.
The method used to pull passive funds together into an overarching strategy is another area of innovation. Steve Charlton, defined contribution proposition manager Europe at Vanguard, explains that its Target Retirement Fund uses a tax-efficient Common Contractual Fund (CCF) wrapper for its funds, effectively creating a “fund of funds of CCFs”.
“It’s constructed entirely from passive building blocks and is a first of its kind – we’ve added some alternative thinking around how that is delivered.”
As pension funds go, NEST is a comparatively long-term investor in alternative indices – it made its first moves into the strategy in 2014. It invests in the HSBC Global Investment Funds (GIF) Economic Scale Index GEM Equity fund and the Northern Trust Emerging Markets Custom ESG Equity Index fund.
“One fund has a value bias and the other a momentum bias,” says Fawcett. “There’ll be times when one outperforms the other, but we believe there are additional benefits from systematically rebalancing between the two.”
It’s thinking about this in terms of a ‘fee budget’ and asking where you can get the best return
Alistair Byrne, senior DC strategist at State Street Global Advisers (SSGA) further develops Fawcett’s theme of rebalancing allocations between funds as required. He argues that while underlying funds might be passive, “there is still a case for active or dynamic asset allocation over time. It’s thinking about this in terms of a ‘fee budget’ and asking where you can get the best return for your investment.”
One of the big drivers for creating low-cost (and as such predominantly passive) strategies has been the default fund charge cap. With a review of the cap imminent, it’s possible that there could be a further reduction from the 0.75% limit, as well as debate over whether transaction charges should be included within it.
Either or both outcomes point to the continued use of passive strategies for DC defaults – but options even within that sphere could start to become limited.
It would be very difficult for some contract-based schemes to evolve beyond the basics because of the administration costs
“I think a further reduction in the cap would become challenging,” says BlackRock’s Finn. “We would ideally like the investment universe to not be further constrained. It would be very difficult for some contract-based schemes to evolve beyond the basics because of the administration costs that they bear.”
Even in trust-based schemes, says Finn, there is little room for movement. “Many schemes are coming in at around 0.6% at the moment, so the ability to squeeze that down is limited. It is in members’ best interests not to push down the investment component of the cap.”
A default fund that delivers diversification, transparency and liquidity at low cost while generating market-beating returns, sounds like the dream combination for any DC default.
There is still plenty of room to innovate around those goals – and much to be done to make sure that schemes are well placed to implement new ideas.
However, creative use of passive strategies, such as alternative indexation, looks set to dominate the default landscape for the foreseeable future.