PPF: Driving factors matter for active and smart beta allocations

Many schemes have started using smart beta strategies: around 70 per cent of European schemes worth $10bn (£6.9bn) or more reported having a smart beta allocation, a survey by index provider FTSE Russell showed last year.

Speaking at the PLSA Investment Conference last week, St Hill said it is crucial schemes dig deeply into how funds achieve their returns.

“There is absolutely no substitute for spending time trying to understand the underlying strategies. If you don’t understand it the first time, ask more questions,” he said.

“In our process we asked tons and tons of suppliers to go through explaining how they went about structuring the indices. We asked them for data on how they went about designing the ideas. We asked for independent verification from academics.”

Alpha fees for factor risk

The fund’s relationship with smart beta has evolved since 2010, St Hill said, when it invested £200m in the strategy.

He said it started off as an exercise to try to understand why some managers outperform and others underperform. “What we found was that a lot of what was being reported as alpha was actually just factor exposure in some of our portfolios.”

He said the PPF later found that some of its active managers were largely taking factor risk, for which it was still paying alpha-level fees, and in 2013 the fund changed the reference index for all its equity managers to a smart beta index.

“This nudged managers towards picking securities which we thought on average would deliver a better risk-adjusted return,” he said.

However, St Hill added: “Particularly with benchmark-agnostic managers, what happened was they went from ignoring the cap-weighted index to ignoring the smart beta index. So, although we had on average a better reference index we didn’t always have better performance from individual managers.”

In response, the scheme introduced a pure smart beta allocation, which according to St Hill allows it to “dial up the active risk inside the fund or dial down the active risk inside the fund depending on whether we think it’s a good environment or a poor environment for stock picking”.

Andrew Ang, managing director at asset manager BlackRock, said schemes should look at the factors used in their portfolios to ascertain whether they can get the same returns for cheaper.

“We need to look through asset class labels to the underlying things that actually do matter,” he said. “Taking into account factors in your overall portfolio construction creates more robust, consistent solutions.”

Ang said that factors “empower” active management. “When we find... true alpha, we should be willing to pay for that handsomely. But anything that we can do for cheap to provide the basic nutrients, we shouldn’t be paying for that and [should be] saving up alpha budgets for where it really matters.”