How is UK pension schemes’ appetite for smart beta changing?

Simeon Willis: For me, the interesting development to look out for is whether the stream moving from passive into smart beta and from active into smart beta is going to be part of a continued theme or is a one-off step change that will not be repeated.

When I speak to independent trustees, they are very sceptical about the scope to deliver outperformance. They see the benefits, particularly for a large scheme with an in-house team; where it is a means to get cheap implementation of their own ideas, it is a great solution.

However, for a smaller scheme, looking to get active outperformance for passive fees, I have not really spoken to anyone in the independent community that thinks smart beta is the answer. So I guess it is a big question mark; I am intrigued to see where we go.

Maxine Kelly: So it is not necessarily a case that small schemes see smart beta as a cheap way to get active, while larger schemes see it as passive-plus?

Willis: I think large schemes seeing it as passive-plus, or their own way of implementing, is what smart beta is perfect for. On the flip side I think a good proportion of small schemes looking to generate active performance with passive fees are likely to be disappointed. The appetite depends on whether all the smart beta advocates have already made the switch and so you are not going to find a continual stream of people moving across, because they already have.

Stephen Miles: It’s difficult for the smaller schemes because of the governance demands; it is not easy to execute well in this space. So unless they have in-house expertise which costs, or they end up outsourcing the governance to someone else – a step towards the old active management model – it can be hard to execute.

Kelly: Is timing a barrier to entry for a lot of pension schemes?

Small schemes looking to generate active performance with passive fees are likely to be disappointed

Simeon Willis, KPMG

Richard Hannam: Yes, different scenarios will work well at different times. These strategies are more defensive in nature. So you would expect to see low-volatility performing well when markets are falling. High-quality would be another example of something a bit more defensive if you look at the securities that end up being overweight, on a relative basis, in that index.

However, more recently that has not been so much the case. Over the past few months markets have been strong but actually the lower-risk strategies, perhaps the more defensive strategies, have done well. For clients, you get this issue of timing and periods when certain factors and certain exposures do well and periods when they do not. So if you are doing single factors, you are then running that risk relative to cap weight.

If you sit there and make that decision and a year later it is negative, and two years later it is negative, and three years later it is negative, everyone is getting nervous. So you get a lot of short-term monitoring of what should be a long-term decision.

Alex Koriath: I think you need to go a step further beyond just saying, ‘Some are defensive and others are not.’ You need to look at what underlying factor exposures you are actually getting in alternative beta products and how these are valued.

For example, we look at the exposure you have to small cap, to value, to momentum. If any of these have done really well and the factors are relatively expensively valued, then you might not want to invest at this point. I think you have to be intelligent in your approach; you have to understand what you are getting and how what you are buying is priced.

If you do this, you will then get a higher quality dialogue – instead of only talking about great-sounding headlines like ‘minimum volatility’. Minimum volatility just sounds great: everyone wants a stock that has zero volatility and great performance. However, it is a lot of marketing talk. Investors need to look beyond that.

Miles: The other dimension is the time horizon. There is not a lot of focus on the question, ‘What time horizon do you need for what you are trying to capture?’ For a lot of the back-testing, proponents will say over 20 years that, on average, this works. So you might be buying something that, on average, say over even 50 years is a good idea. If you could make this decision, close your eyes, wake up in 50 years and look back and then get your personal appraisal, ‘Has it worked – yes; have you done a good job - yes,’ then, fine. But that is just not how it works, is it?

Minimum volatility sounds great: everyone wants a stock that has zero volatility and great performance. However, it is a lot of marketing talk

Alex Koriath, Cambridge Associates

After a year, or three years, as has been mentioned, people do look back to judge success. That is not long enough for active managers, let alone smart beta, because a lot of the returns are beta-like.

It is the same as looking at equity returns over the last one or three years and, if they have been poor, deciding that investing in equities is a bad idea.

Ronan Kearney: Just on that point about being different to active managers, most active strategies that we see, we can replicate in an index. So we can actually publish an active strategy as an index. Think of an index as an alternative word for fund, but more efficient. That is one of the reasons why there is a proliferation of them now – it is that asset managers are realising it is an awful lot easier to publish an investment index than it is to create and launch a fund.

I may be cynical about these things, but if you are not 100 per cent convinced that your strategy is optimal, but you are pretty convinced it is optimal within a range, you might do 10 rather than one, and at the end of the year you might pick one.

I am not saying this is happening, but you can see the potential might be out there to do that, so it allows people to innovate quite quickly. One of the things we are very interested in is the gap between the promises and the actual realities – the execution gap, if you like.