(July 16, 2013) — HSBC Global Asset Management has become the latest fund manager to offer a range of smart beta funds through alternative indices, but is the institutional market ready for them?
Over the past few years, the idea of smart beta or alternative indexing, where fund managers use something other than the market capital of companies to weight them on an index, has started to take flight.
HSBC Global Asset Management announced on July 15 that it was to bring a range of new funds to market, using its Economic Scale Indices, which rank companies by its own Value Added calculation.
The fund manager produces this figure by taking the difference between a company’s output (sales) and its inputs (purchases from other businesses), before summing all disbursements published on the company’s financial accounts, adjusting to a common current and then coming up with a value figure for the year, and over an average of five years.
The first fund (ESI ACWI Equities) is due to be launched on October 1, subject to regulatory approval, with three further funds (ESI Global, US, and Japan equities) being submitted to the regulator now, with an anticipated launch in the fourth quarter of 2013.
Chris Cheetham, global CIO at HSBC Global Asset Management, said he was witnessing “a paradigm shift” in how investors are challenging the so-called conventional wisdom of market capitalisation-weighted indices.
But is there really a dramatic shift in investor sentiment? Or are fund managers just hoping for one?
It’s certainly fair to say there’s been a plethora of similar funds and indices appearing on the market in the past few years.
Benchmarking giant FTSE has one of the best known alternative indices on the market, the FTSE RAFI, which uses sales, book value, cash flows and dividends as ways of calculating companies’ weights on the index.
In the past 12 months, it’s launched another four alternative indices, all with slightly different focuses. These are:
1) Cyclical & Defensive (Feb 6, 2013). Designed to enable investors to implement their economic view. Cyclical indices are sensitive to economics while defensives are relatively insensitive.
2) SLQ (Nov 27, 2012). The Super Liquid Indices, designed to mimic the behaviour of the parent index but containing only the most liquid of the constituents, reducing costs of implementation, while maintaining the industry weightings.
3) Target Exposure Commodity Indices (March 19, 2013). Diversified long/short commodity indices using Dynamic Portfolio tactics.
4) Implied volatility indices (Feb 27 2013). Shows the volatility of the underlying index (FTSE100), calculated from out-of-the-money options available on the market.
Carl Beckley, managing director and relationship manager for EMEA at FTSE, told aiCIO while it was easy to knock market cap-weighted indices as they’d been around for the longest, the reality is that they are still likely to outperform in long bull markets, and in his opinion it is some time since we have had a long bull market. For this reason people are looking for alternative investment approaches.
“The gestation for institutional investors to come on board can be long because this is new, and because as a whole there’s a question mark over whether it’s a passive or an active strategy,” he said.
“That sounds like a small thing, but the problem is [the strategy] is sort of both. Investment consultants didn’t know where it sat either. And pension funds often want live track records, as opposed to backtesting, of at least three years.”
Today, the big four investment consultants of Mercer, Towers Watson, Aon Hewitt, and Hymans Robertson are on board with the idea, which has made a big difference, Beckley added.
The volume of money into these new indices is still small–FTSE believes across all of its alternative indices it has $20 billion to $25 billion-but Beckley puts that down to investors’ toe-in-the-water approach. Typically, investors who are interested in the strategy will invest 5% to 10% of their passive allocation and wait and see how it performs.
“Interestingly we’re also seeing that when an investor wants to change an active manager, rather than give the whole active fund to a new manager, they’re considering alternative beta alongside a new manager. The potential returns are similar to an active manager at a lower price,” he added.
Craig Chambers, managing director of Old Mutual Global Index Trackers, which manages funds to three alternative indices, said he’d seen many large investors in Europe actively use alternative beta solutions.
“Evidence does suggest that indices form an active element of portfolio management strategies, and that alternative indices are useful tools in achieving desired outcomes,” he continued.
“Many alternative indices are effectively active management using sophisticated quantitative processes and industrialising the end portfolio, thereby achieving great economies of scale. The challenge now lies in intelligent implementation, with a focus on minimising costs for the client.”
State Street Global Advisors (SSgA) launched its Issuer Scored Credit Index in April 2011. This index also uses financial factors to re-weight an index: its selling point was that traditional cap-weighted bond indices are most heavily weighted towards the most indebted issuers, which was a risky thing for investors to put their money against.
Across this and its other volatility-weighted index, it holds $47.3 billion. To put that in perspective, Morningstar data recently showed $131 billion in advanced beta strategies in funds.
Niall O’Leary, head of portfolio solutions at SSgA, told aiCIO he had seen steady growth over the past few years, but admitted that traditional indices still dominated the market.
He, like Beckley, cited the increase in investment consultant backing as one of the drivers for interest.
“Within equities low or managed volatility strategies have seen increasing flows, as have fundamental indices which favour lower valued stocks, while higher yielding strategies have proved popular in the ETF space,” he said.
“A good example of this is the SPDR S&P US Dividend Aristocrats ETF which was launched in October 2011 and which has grown to $1.35 billion in size. This fund only invests in the 60 highest yielding US stocks from the S&P 1500 Composite Index provided they have paid an increased dividend every year for at least 25 years.”
Fixed income strategies are also popular, along with the SSgA Euro Core Treasury Bond Index Fund which only allocates to sovereign bonds issued by Germany, France, and the Netherlands on a 40:40:20 basis, providing a core eurozone bond strategy while avoiding the pitfalls of investing in the periphery.
Consultants told aiCIO that the fees were still too high to attract some institutional investors, particularly when the strategies had such a short actual track record.
Phil Page, client director at Cardano, said as an example, an investor might pay 10bps as an institutional investor for a Japanese equities index, but a fundamental index could see charges rise to between 25 and 30bps.
“It’s not a lot, but if the reason you’re investing passively is to keep the costs down it might be enough of a reason not to,” he said,
“It comes down to if you think you’d be better off paying the extra few bps in return for a better return. Advocates would also argue that it produces a more stable return profile as it avoids price excesses and potentially defaults.”
John Belgrove, partner at Aon Hewitt, agreed with the ball park figures, but stressed there was a wide range of charges, depending on how the index is put together: those with more third parties involved inexplicably charge more.
SSgA’s O’Leary recognised that advanced beta strategies attract higher fees than traditional passive strategies, and that for some investors it was an issue.
“However, for many investors there is a willingness to pay a modestly higher fee for an advanced beta strategy, particularly if it provides them with a particular exposure they desire, or protects them from risks they are seeking to avoid. I would sense that as investors become increasingly familiar with the attractions of advanced beta then the issue of fees is less of a concern,” he said.
Will the market take off? The consensus seems to be that bigger inflows will certainly take place in 2013, but whether they’ll be big enough to meet fund managers’ expectations remains to be seen.
Belgrove said: “There are a few brave individuals who predict trillions in terms of flow over the next five to 10 years, which is quite something when you consider they maybe make up 3% to 4% of the index market so far.
“There is plenty of scope and a decent investment case, so I could see a few hundred billions flowing into appropriately pooled funds.
“But don’t get fooled by the vast range of funds being launched,” he concluded, saying the flows were unlikely to match fund managers’ expectations.