How to Implement Smart Beta Strategies | Chief Investment Officer

(October 2, 2013) – Smart beta strategies should only be used across a broad selection of assets, according to consultancy Towers Watson.

In a white paper on the adoption and implementation of smart beta strategies—which have become increasingly popular over the past year as investors seek out tax and cost-efficient returns—Towers Watson concluded that smart beta works best when implemented across a broad investment universe.

“Breadth and depth are instrumental to the successful application of approaches that are systematic in nature, such as smart beta. We do not think a narrow or too concentrated opportunity set is suitable for the use of some smart betas,” the report said.

“This might lead to unintended risks, such as over-concentration in certain industries/sectors/countries and/or for stock-specific risk becoming too dominant in the portfolio.”

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Towers Watson believes that broad approach should apply to geographical regions too, recommending a universe which features both developed and emerging markets.

While picking developed-only or emerging market-only universes may also work, drilling down to country-specific strategies was not ideal, the paper said.

Investors should be aware of the more aggressive smart beta strategies that may underperform significantly in bear markets or sharp drawdowns.

Perhaps the biggest issue for newcomers to smart beta strategies is how to benchmark results.

It is also important to realise that smart beta strategies are generally not constructed as relative return products, and typically have high tracking error relative to a market capitalisation portfolio, the paper continued.

This means that the strategies will perform very differently to market capitalisation weighted portfolios and can underperform market capitalisation substantially, potentially over a long period of time—typically during strong market rallies and bubbles.

Towers Watson suggests you throw the idea of benchmarks out of the window, and focus on aligning the strategies with the investment objectives, and then monitor them regularly to ensure they are still aligned.

However for some strategies, taking traditional benchmarks and applying them in a different way may be a useful tool.

The paper noted: “For some smart beta approaches, the strategic rationale may be to reduce the overall equity beta exposure of the portfolio (that is, de-risking). In this case, we are supportive of the strategy being measured against a market capitalisation index over the long term on an absolute risk-adjusted basis.

“We would also support benchmarking against a suitable combination of a market capitalisation index and cash (which would be another way of lowering the beta of the equity portfolio or benchmark). In cases where a manager is managing their approach against a specific index (for example, an MSCI minimum volatility index) comparing to said index is also appropriate.”

The full paper can be read here.

Smart beta

(October 2, 2013) — Rothesay Life has completed its second bulk annuity transaction in a month, securing £484 million worth of liabilities for the UK Philips Pension Fund.

The transaction saw gilts and cash held by the pension fund swapped for an insurance policy that will provide benefits for pensioners in payment and their contingent beneficiaries.

This is the second deal announced inside a month for Rothesay, which secured a £440 million transaction—this time for a portion of the active members—for the InterContinental Hotel Group in September.

Rothesay Life has been one of the most active players in the market when it comes to mid-market level pension risk transfers, but it has also dealt some of the market’s smallest and largest transactions.

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Its deals have ranged from a £60 million buy-in deal for Radius Systems in April 2011 to a £1.3 billion longevity swap with the British Airways APS Scheme in December 2011.

Clive Wellsteed, partner at consultants LCP and adviser to the pension fund trustee, said the key challenge was helping the trustees to understand which parts of the total £3.5 billion liabilities provided best value for the risk reduction to be achieved.

Transactions for pension risk transfers in the UK have now exceeded £5 billion, overtaking the £4.4 billion worth of deals achieved in 2012.

Ian Aley, a de-risking expert at Towers Watson, said the recent improvement in bulk annuity pricing had resulted in more pension schemes taking advantage of the favourable investment conditions.

“We have every indication to believe this is still the case as pricing remains attractive. Many funds now have set market triggers and are monitoring the market to complete transactions when the cost and risk conditions are favourable,” he said.

“Schemes with gilt investments are still taking the opportunity to exchange these for an annuity that provides a better match for their liabilities for little or no cost and the rise in the equity market has meant that buyouts might be within reaching distance for many schemes.”

Aley went on to predict that the buyout and buy-in run was far from over, and that he expected £6 billion to be transacted by the end of 2013.

Rothesay Life has recently been put up for sale by its owner Goldman Sachs. Last month, press reports suggested two-thirds of the insurer had been agreed to be bought by three companies: Blackstone, GIC, and Mass Mutual. The acquisitions are yet to be confirmed by any party.

It is expected, however, that further pension risk transfer deals will be announced by Rothesay Life before the end of 2013.