What factors should schemes consider within smart beta?

Pensions Expert: How significant a problem is the proliferation of factors and what do you think can be done about it?

Scott Richardson: No reasonable person would make a case for more than five, maybe 10 factors. At some point you get more factors than there are assets. Those arguing for more than that are causing a lot of confusion.

Robert Holford: It is prolonging the time it is taking to get these things into people’s portfolios. Multi-factor is solving that problem: you can take an 18-month period and after that you will have picked something that will do all your factors and you can get back to focusing on other important issues, such as where yield is going to come from in the next 10 years.

Factor timing is very hard, so we prefer to just be humble and say, ‘Harvest these things in a low-fee, risk-balanced, efficient manner, everywhere’

Scott Richardson, AQR Capital Management

Simon Hill: Trustees just get confused. I am still, though – given that the fees are relatively low – surprised by how many people want to have product in this area because the assets under management are still relatively low. So why are people so keen? Maybe is it the ease of production?

Steve Artingstall: I think it is because that is where the asset flows are moving and you are seeing negative asset flows from traditional asset strategies. As a large institutional investor, we felt that these alternative risk premia were much more transparent and reliable.

And you could access them in a more consistent fashion by using systematic strategies, as opposed to having variable, uncertain exposures for our active management, which was less attractive.

Pensions Expert: Which factors are particularly popular at the moment and where do you see opportunities in the future?

Holford: In the UK market, fundamental value has been probably the biggest factor. By and large, it has been upgrading passive to something else, rather than moving from active down.

Railpen, some of the other big institutions and the Pension Protection Fund are moving to using minimum-variance benchmarks. So at the top end there is a much more sophisticated approach, and I think minimum variance is something we see coming through via the UK consultants.

Obviously it is a factor that has performed very well for quite a long time, so you do wonder the extent to which this is people crowding into something others have made a lot of money out of.

Richardson: We tend not to offer things solely in a long-only form. So you might have long-only and long-short exposure to momentum, value, and defensive, say, standalone for equities.

But we see the greatest demand for long-short multi-style, multi-asset class strategies that invest across multiple geographies, so it is a pretty diversified product. We do not see as much demand for a single-style strategies focus on just one asset class – that is an inefficient portfolio approach.

What do we think is going to be the best factor next year? I have no idea. Factor timing is very hard, so we prefer to just be humble and say, ‘Harvest these things in a low-fee, risk-balanced, efficient manner, everywhere’.

Holford: I would not expect you to have seen the demand for single factor in the advanced beta category we are looking at, because it is actually falling.

A lot of trustee boards are quite concerned about damaging their potential for return, and they think a low volatility approach helps them to square that circle

Simon Hill, Xerox HR Services

Where people are buying single factors, often they are sophisticated investors that are looking to buy those factors and manage the interactions themselves. People in the wholesale space and in the smaller institutional space are saying, ‘Hang on, we do not have the governance to even start doing this’.

Hill: We have not talked about crowdedness, but that is an objection. When a factor gets well established, it does get crowded. It happened with small cap, and it certainly happened with some of the actives during the financial crisis and the run-up to that.

Artingstall: Do you think it has happened with value over the past 10 years?

Hill: Arguably. Scheme interest has been around minimum volatility and fundamental indexation as alternatives to market cap, and also ways to get equity exposure but still reduce the risk.

A lot of trustee boards are quite concerned about damaging their potential for return, and they think a low-volatility approach helps them square that circle to some degree. They might give up a bit in return, but not as much as they get as a reduction in the equity volatility.

Jonathan Reynolds: That is a very good point, Simon. In the defined benefit space, as integrated risk management takes hold and more trustees come to terms with that, understand what it means and are actively managing their portfolio with that in mind, there will be a greater focus on risk.

I think minimum volatility has an attraction. My understanding is that it has not woefully underperformed; in fact, it has probably been better than market cap. So the idea of lower risk and higher returns is hugely attractive.

Hill: But it has partly outperformed because everybody has been selling it and a lot of people have been buying the idea, so you worry about the value price you are paying.

Artingstall: You can have one particular factor that looks very attractive from a risk-return perspective, but you need diversification, because it is very likely that what has done the best in the short term is not the best in the future.

Low volatility has carried on longer than people expected, and people were calling the top a long time ago. But it is very hard to do that and that is why you do need to diversify factor exposure.

Richardson: People tend to forget multi-style diversification is so important.

If you have a valuation exposure in that smart beta wrapper and defensive gets more expensive, value and defensive become more negatively correlated. When you put the two together, you dampen the exposure to the more expensive, defensive stocks.

So you can think of it as implicitly timing the exposure of the other non-value themes when you have value in the portfolio.

Hill: There are broadly two different types of approach to multi-factor. One is this kind of strategic diversification. The other is more a timing of momentum in the factor, ie if you are doing that kind of data analysis, you pick up those things quicker than a traditional manager would do.

Some of the minimum-volatility approaches work on that basis, that you can see the pricing volatility changing in a market before the market actually moves. Some hedge funds have exploited this.