How a smart blend of alpha and beta can maximise returns

In the quest to find an investment proposition that delivers strong performance at the lowest cost, managers use a range of solutions that span from low-cost index exchange traded funds to premium active strategies.

With the growing choice of innovative smart beta ETFs coming to the market, can pension funds deliver value by incorporating these products to sit alongside market capitalisation index ETFs and actively managed funds?

To answer this question, pension fund managers should ask:

1. Are there any lower-cost smart beta solutions designed to deliver the same investment outcome as an actively managed fund?

2. Are there any smart beta solutions designed to deliver an improved return over a market-cap index to justify the additional cost?

Blended multi-asset portfolio

For example, a UK pension fund is looking to provide a sustainable retirement income for stakeholders. It needs a mix of capital preservation and appreciation to maintain the longevity of the pension pot.

Accordingly, the portfolio will likely have a core mix of equities and fixed income that is supplemented by investments in other asset classes to provide diversification and to reduce volatility. 

A value judgment will need to be made by the manager in each investment to ensure the performance return is not eroded by unnecessarily high fees.

Below is an example of a portfolio that incorporates a benchmark tracker, smart beta approaches and an actively managed strategy. 

UK equities

In more developed markets, a number of active funds will have investment approaches that follow the characteristics of established indices such as the FTSE 100. 

In this scenario, the pension manager may find better value through a cheaper systematic investment such as a multi-factor UK equity ETF, designed to incorporate a stock selection process that provides the greatest exposure to the main factors driving equity performance and equalise risk contribution across sectors and stocks.

Emerging market equities

A manager looking for capital appreciation may believe that emerging market investments are highly specialised and the fees for an actively managed approach may be justified. 

As long as the historical returns are consistently strong relative to an EM benchmark, the additional expense may be worth it for the EM team’s experience, access to research and analyst support to pick the best-performing companies in a concentrated portfolio. 

Fixed income

Many of the bond indices ETFs track are market cap-weighted benchmarks, which are also used as a starting point by active managers in building a portfolio.

The use of these benchmarks leads to an investment approach whereby more money is lent to the bond issuers that have issued the most debt.

An alternative is a systematic approach which lends more money to debt issuers who have the greatest ability to repay that debt.

Known as fundamental fixed income, this smarter method gives ETF investors intraday liquidity and real-time pricing, which may be less costly than active funds.

Commodities

An allocation to commodities is a great diversification tool, and investors can gain potential upside in the current environment where many commodities are trading below their marginal cost of production. 

While the obvious choice is to track a well-recognised market benchmark, a smarter approach to minimise the effects of contango – where today’s commodity price is lower than its expected price for delivery in the future – would be to use a Ucits ETF that tracks a longer-dated index. For example tracking commodity futures three months ahead, for their core commodity allocation.

Pension fund managers should do regular due diligence to ensure all investments present value for money and that performance is not eroded by unnecessarily high fees.

Howie Li, is co-head of Canvas at ETF Securities