Analysis: For some time now, financial punters have prescribed passive investment as the low-cost panacea for investors bloodied by years of underwhelming active management.
S&P data indicates that between mid-year 2016 and mid-year 2017, active funds investing in pan-European equities achieved an average asset-weighted performance of 17.6 per cent. This compares unfavourably with the S&P Europe 350 index, which yielded 18.6 per cent.
Merely one in three active UK managers beat their benchmarks over 10 years. Investors now have sufficient cause to start shifting their powder from an underperforming and opaque investment practice into something better.
You are going to be exposed to the full volatility and cut and thrust of markets
Mark McNulty, JLT Employee Benefits
A structured equity strategy could help active-weary schemes secure returns while covering against losses.
Cap your returns, limit your losses
In truth, a structured equity approach does not entail a total departure from active management. In its paper, ‘The Case for Structured Equity: An Active Quantitative Investment Strategy’, Vanguard described it as “a quantitative active management strategy with an annualised projected tracking error of less than 2.5 per cent”.
Structured equity can be thought of as a form of enhanced indexing. Adam Gillespie, principal at Punter Southall, defines structured equity as an asset class. The product allows schemes to swap potential returns for protection against market falls, thus limiting tracking error.
For example, an investor could base a structured equity product on an underlying equity index, and cap its total returns on the product at 20 per cent over a three-year period, in exchange for an equity market safety net of losses of up to 20 per cent.
“It’s an asset class that can be used by pension schemes to improve the certainty of their investment outcomes,” he said. “You can use it as an asset class that could generate returns. You can use it as an asset class to try and protect you against market falls.”
Gillespie described structured equity as “a mechanical product”, which has a typical timespan of three years. Schemes might, however, buy equity derivatives to provide short-term protection against equity market falls for a period as brief as one month.
This predetermined, so-called mechanical nature of structured equity appeals to investors, as it helps to reduce the level of manager risk within a scheme’s portfolio by guaranteeing performance against a set level of losses, Gillespie added.
Structured equity is not without risk
The global financial crisis in 2008 deterred many investors from more sophisticated investment products, which had fed into the perilous uncertainty and absence of transparency that contributed to the collapse in financial markets.
Mark McNulty, head of investment solutions at JLT Employee Benefits, said that since 2008, the industry is “seeing increased interest again in quantitative investment management techniques”.
This includes structured equity, which McNulty categorised as “an investment style” which consists of “taking smaller bets and hoping to squeeze a bit more out of [a manager’s] equity beta exposure on behalf of pension funds”.
According to McNulty, prospective investors need to assess how the structured equity manager plans to beat their benchmark, the quantitative process behind their strategy and its robustness in different market environments. Conventional due diligence criteria, such as manager skill and track record, also apply.
“At the end of the day, this is going to give you full exposure to equity markets… it’s not a no-risk strategy. You are going to be exposed to the full volatility and cut and thrust of markets,” he said.
Cheaper than traditional active management
Active equity managers have consistently failed to justify the fees they charge schemes, given their collective inability to build funds capable of beating indices. Structured equity comes at less of a price.
Mark Ashworth, chair of professional trustee company Law Debenture, said: “It’s a low-cost way of accessing equity alpha, to the extent it’s available.”
Ashworth contended, however, that structured equity remains vulnerable to the same charges laid against other forms of active management.
Jersey teachers’ fund puts faith in active management
The States of Jersey Teachers’ Superannuation Fund has bucked the current trend away from active management and increased its exposure to active equities, reducing index shares.
“The attack would be: structured equity is just another form of active management. Active management in the long term does not add value,” he said, noting that it was therefore subject to the same criticisms as active equity was generally subject to.
He added: “It may be low cost, so the amount of regret risk may be correspondingly low along, with a relatively low tracking error.”
