Telegraph welcomes smart beta addition to TDFs

Lower costs and heightened scrutiny of active management have contributed to significant inflows into smart beta strategies in recent years, but experts have warned that the funds’ popularity could distort performance.

State Street Global Advisors, the provider of the Telegraph Group’s fund selection, has added smart beta, along with high-yield and emerging market debt, across its range of target date funds.

Savers in the growth phase of their glidepath will see their money invested in value and small cap factors, transitioning to quality and low volatility strategies as the fund matures and looks to derisk.

A portfolio combining multiple styles, most importantly value, provides some protection as and when other factors become more expensive

Scott Richardson, AQR Capital Management

Dipak Wadher, pensions manager at Telegraph Media Group, welcomed the move, arguing that the shifting allocation of target date funds allows for the use of smart beta.

“We use TDFs as they have the ability to continually evolve and utilise new investment ideas, such as smart beta, as they develop, enabling increased diversification and downside protection at a low cost,” he said.

Beat the crowds

While smart beta’s increasing popularity is testament to its merit as a low-cost boost to returns, that popularity can negatively impact returns, where investors look at past performance as an indicator of future returns.

“People will buy strategies believing that because they have had success over the last few years, that success is going to continue,” said Charles Aram, head of EMEA at smart beta specialist Research Affiliates.

Under such behaviour, smart beta factors might perform well not because the underlying companies are strong performers, but because investor interest in them inflates their share price.

Aram said that by looking at valuation multiples across factors relative to history, it is possible to identify factors such as low volatility as overvalued, and others, like value, as historically cheap.

“You would expect those overvaluations relative to their own normal historical mean would revert at some point,” he added.

This might be not such a problem for an investment manager like State Street Global Advisors, which tracks valuations for all smart beta factors.

“It’s obviously a possibility with any investment strategy that that valuation gets out of line,” said Alistair Byrne, senior DC strategist at SSgA. “We factor that into our expectations about what the factors can do in the future.” 

Diversify your factors

However, crowding could be a bigger concern for trust-based schemes in the future, especially where they have issued mandates for investment in just one or two factors.

“We agree that investors should monitor their portfolios for signs of crowding,” said Scott Richardson, managing director of AQR Capital Management. “However, we currently do not find that crowding presents an immediate cause for concern for investors in smart beta.”

Rather than trying to time the growth of factors in the market, Richardson recommended diversification through multiple, uncorrelated factors.

“A portfolio combining multiple styles, most importantly value, provides some protection as and when other factors become more expensive,” he said.

Pick an approach

Gavin Orpin, head of trustee investment consulting at LCP, agreed that diversification is essential, and argued that the most widely used factors exist because of underlying behavioural biases and long-term prospects.

“What we’re looking at is factors that... effectively haven’t been crowded out through time,” he said.

He warned schemes not to pay too much for smart beta strategies, which can now cost around 5 basis points more than a passive solution, but recommended strategies with a narrow factor focus, rather than broad alternative indices. “The key benefits really come from the stocks that show significant factor exposure,” he said.

Those strategies may carry a higher fee, noted Joanna Sharples, investment principal at Aon Hewitt, as they are often manager-led and similar to active quantum strategies.

Sharples said that smart beta has had relatively little penetration in DC so far, but welcomed its use, particularly in lifestyle strategies. She recommended that before allocating trustees seek education on investment style, and also on the techniques employed by their current passive mandates.

“It’s a great opportunity to get a bit of a refresh... it’s good governance,” she said.

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