LPFA emphasises quant and beta strategies in investment outlook

For the full The Specialist report on investment trends, click here to download the PDF

A fresh investment strategy is in the making, which will include greater emphasis on quantitative approaches and alternative indices. It will also focus on property, infrastructure and private equity.

“We will look at the performance, the correlation structure, the factor risk,” Gracian says. The aim is greater diversification and “smoother returns”.

More quant in new investment strategy

“On the equity side, we are very much looking at quant techniques,” he says, because “we can reduce our downside risk”.

Gracian, who previously worked at Gulf International Bank and TRW Pension Fund, notes that he has a “significant quant background” and is planning on hiring more people with similar expertise.

The strategies are most commonly associated with equity trades based on computer simulations making specific assumptions about stocks and patterns in price changes.

John Hastings, partner and senior consultant at Hymans Robertson, which previously advised the LPFA, says: “As with all products, it starts out with whether you actually believe it works. If it’s not working, how would you know why, and the degree to which it’s not working.”

Pension fund trustees can find this unsettling, he adds; it can be difficult to explain the reasons for poor performance.

Many quant strategies are not designed to work in every market scenario.

“The reason it goes wrong is very often because there’s a breakdown in the pattern,” explains Hastings. “A quantitative model isn’t going to work all the time; it’s just that because it is of a black-box nature, it’s harder to explain.”

He adds that one of the risks with quant strategies is that some models are used more than others. “You have a situation where a large number of quantitative managers in long portfolios – but also hedge funds or long-short portfolios – are running the obvious metrics in this area.”

Therefore, the challenge is to find ways of investing that are proprietary because, says Hastings, “you can’t buy any faster than the others are buying”.

These approaches are also often used by active managers to whittle down the number of stocks they analyse. This makes it hard to have a clear separation between quant and qualitative analysis, he points out.

Toby Goodworth, head of risk management at consultancy bfinance, agrees: “Discretionary or fundamental funds still use quantitative models to screen. There is no clear delineation between quant and discretionary strategies.”

Quant equity strategies do have a place, because they are able to deliver a return stream investors cannot get elsewhere. Market neutral is very difficult to do on a discretionary basis, he adds.

Goodworth says the main challenge with using the method is that “it’s very easy to be seduced by backtests. I have never seen a bad one. Sometimes it doesn’t hold up, generally you see slightly less return and higher risk going forward”.

According to Goodworth, one should apply a “simple is better” rule and understand when the model will stop working. But in order to do so, you need access to the parameters used: “You have to understand the maths behind it, but you can only do that if they talk about it.”

Alternative, smart, or (not so) new indices

Alternative indices can be seen as a simple form of quant, and the LPFA is also keen to invest in those.

Gracian, who avoids using the term smart beta, says: “Part of dealing with uncertainty is about not putting all of your eggs in one basket, both across and within asset classes.” He adds that alternative beta allows investors to diversify and to manage volatility. This, he says, is important because “volatility is more predictable than returns”.

But he is not the only one who has become interested in alternative indices. According to Ursula Marchioni, head of EMEA equity strategy and exchange traded products research at iShares, alternative beta will be ahead in terms of growth rate among ETPs.

“At the end of August 2013, we recorded $50.6bn (£31.6bn) year-to-date inflows in non market-cap-weighted equity ETPs globally, or 37 per cent of total flows into ETPs tracking this asset class,” she says.

Marchioni stresses that alternative beta will outperform traditional indices in certain market scenarios, but underperform them in others.

“The key is in the outcome or market scenario investors are preparing for,” she says. “Investors should select their beta depending on their expectancy of the future.”

Marchioni does not consider alternative beta strategies ‘smarter’ than traditional beta, and therefore prefers to call them ‘new’ beta, “to represent a group of strategies that deliver a deviation from the traditional beta towards specific tilts, factors, risks or exposures”.

Bfinance’s Goodworth, who worked in an alternative index equity firm in the past, contends that alternative beta is not new: “This is not a new strategy. People have been investing in smart beta ways for decades.”

He agrees there seems to be more of a focus on these strategies at the moment.

“We are seeing a lot of interest on the active side, people looking to replace active managers with smart beta and then focusing more on alpha,” he says.

Fee-conscious investors can diversify their manager stable by buying alternative beta “cheaper than an active manager and producing an active stream on top”.

There can be problems with alternative indices, however. Some strategies are sensitive to capacity effects, although Goodworth maintains: “With the amount of money in it now, I don’t think anybody is hitting any capacity constraints at the moment.”

In addition, strategies such as low volatility and maximum Sharpe ratio (risk-adjusted return) can have a relatively high turnover of stocks, leading to trading costs.

Hastings says capacity is key to reducing costs: “Somebody may come up with the most wonderful index in the world, but if there’s no money behind it, it’s going to be expensive to manage. Very curiously, the strength of a market cap is you don’t need to rebalance.”

For Hastings, alternative indices are more like passive than active management. “They are trying to take out an active level of subjectivity. It’s just a pure quant application of a set of rules to the index.”

The hunt for illiquidity premia

The LPFA is also set to establish a strong illiquid asset exposure. In the illiquid real asset space, Gracian will seek out “inflation-hedging assets, infrastructure, private equity and property”.

One of his aims is for the LPFA to own more of these assets via direct investments, co-investments and single funds, moving “away from funds of funds and specialised opportunities”.

His team, which he is continuing to expand, selects funds, he says. “Our philosophy is very much to build in-house expertise, to become a centre of excellence like Canadian funds.”

Many of the country’s funds, however, have a much larger asset base. But while the LPFA does not administer tens or hundreds of billions at the moment, it is one of the most active proponents of merging public pension funds since Brandon Lewis, minister for local government, issued a call for evidence on merging schemes.

“From an investment perspective, and it’s a personal view as well, it’s logical and common sense. Only look at Canadian funds. It gives you a better price and better pressure on costs. It gives you better leverage in participating in big deals,” Gracian says.

“Look at how much big Canadian funds and sovereign wealth funds own in Europe and the UK,” he adds. “UK pension funds should be in that position.”

Canadian funds have gained a reputation for being active direct investors, particularly in property and infrastructure. The C$60bn (£36.4bn) Ontario Municipal Employees Retirement System writes that a study, commissioned from Boston Consulting Group by Canada’s 10 largest pension funds, found these funds to comprise four of the top 20 global commercial real estate investors and four of the top 20 global investors in infrastructure assets.

Even if merged, London’s public pension funds could not boast the asset base and buying power of public Canadian funds. However, a merged Local Government Pension Scheme could, considering that the LGPS has nearly £150bn in assets.

But is there perhaps another way? Nicola Mark, head of the Norfolk Pension Fund, is not convinced merging is necessarily theroute to take. “My personal view is that size isn’t the issue, it’s the standard of governance,” she says.

For the full The Specialist report on investment trends, click here to download the PDF

She calls restructuring the LGPS a “high-risk” enterprise, stressing that other options should be looked at in the minister’s call for evidence.

For LPFA investment chief Gracian, a merger makes sense. “It’s about cost, opportunity set and expertise,” he maintains. “If I have a heart problem, I’d rather go to the best heart specialist who can give me the best state of the art care.”

Sandra Wolf is deputy editor of Financial Times service MandateWire Europe