In the second of a four-part discussion, Aon Hewitt's Tim Giles, Axa IM's Madeline Forrester, Nick Motson from Cass Business School, LGIM's Simon Midgen, the PPF's John St. Hill and Russell Indexes' Jamie Forbes discuss the latest smart beta strategies.
Madeline Forrester: The second generation of products becomes more outcome-focused. What outcome are you trying to achieve? The second wave is really about doing as much as we can to control that cyclicality and having multi-dimensional models that look at more than one factor within the strategy, so that you reduce some of that underperformance at certain times in the cycle. And therefore it is a trade-off, it is about finding the right overall return with a level of cyclicality that pension funds can deal with.
Investment banks are coming to us and proposing indexation strategies, formerly strategies they might have been running in-house, but which they have now packaged up
John St Hill, PPF
Nick Motson: The big push for a lot of this stuff is that it overcame the problem of the bursting of the dotcom bubble. During that bubble, pretty much everyone underperformed dramatically. We have already talked about low volatility, and you expect that to underperform in a big bull market, but then at the same time you had value-type strategies and fundamental strategies underperforming, so anything tilted towards low-volatility stocks or value got absolutely crushed in comparison to market cap.
My argument would be that in the long run, these alternatives did their job: they underperformed in a massive bull market and they outperformed in a down market, so they reduced the volatility. And you cannot just look back three years and say: ‘Oh look, if we had invested in this we would have done better’.
Simon Midgen: Was there not some recent research that suggested maybe the volatility effect is not working in the way it was supposed to?
John St Hill: If you buy an index and you find it has securities that have an extremely high price/earnings ratio or an extremely high price/book, then you are necessarily taking an anti-value view inside that portfolio. But if you want to buy low-volatility securities and you find these also give you another factor, and then you complain because this overvalued factor underperforms, then that suggests you had not really given a great deal of consideration to the factors for which you were purchasing the portfolio in the first place.
One of the things we have started to see coming through is that a lot of the investment banks have found their ability to take on risk by running proprietary investment strategies is curtailed because of Basel III. So investment banks are coming to us and proposing indexation strategies, formerly strategies they might have been running in-house, but which they have now packaged up. The bank then generates profit by making a market for the index and by offering the index within a note or in a total return swap.
The second wave is really about doing as much as we can to control that cyclicality
Madeline Forrester, Axa IM
There are some things that historically would have been very difficult for pension fund trustees to capture which are now becoming available. The classic ones are the differences between implied and realised volatility. The idea of an index like that being produced a few years ago just would not have happened. Now, in the course of the past two months, I have seen two different investment banks pitch those index strategies to me.
Motson: Then the trustees’ job just becomes so difficult. Some of the investment banks have got more than 500 indices on their website.
Tim Giles: That is not helping; innovation may actually stifle the market in reality because there is so much indiscernible choice.
Forrester: And particularly in an environment where there is distrust in the industry. The danger is it looks like complexity for the sake of complexity, which I think comes back to the fee question and all of these strategies, be they rules-based or multi-dimensional, should still be low-cost. There will be a premium above pure passive strategies, but those fees should still be much closer to passive than to traditional active strategies.
Motson: RAFI [a type of smart beta index] is just so intuitive. Now, lots of people argue it is just a value tilt, fine, but there is something behind it that makes sense, whereas it is hard to explain some of the mathematical ones.
St Hill: It is fantastically intuitive. But I also think there is something which is slightly counterintuitive to just buying the biggest securities, as you would do for cap-weighted. When you buy a cap-weighted index, you are tending to follow the securities that have gone up the most – and at its logical extreme, cap-weighted indices suggest that the biggest securities should continue to be the biggest securities forever. Any index that does not have that capweighted bias will benefit from being anti-cap-weighted and rebalancing. There are managers out there who have been running those sorts of strategies since the early 1980s, it is just that all of a sudden that research has been picked up and is now being remarketed as smart beta.
Giles: But I guess the worrying thing is if you take an active manager who has been using that to inform his process and then benchmarking against that index, you end up with a series of benchmark-hugging active managers. So you might end up paying more for a quasi-passive approach. In the context of things, it should all be about fees. You need to ensure the fees involved are justified.