How to Build Smart Beta 2.0 | Chief Investment Officer

Concentrated or “targeted” smart beta funds will be the next wave of indexing, according to Morningstar’s Vice President of Research John Rekenthaler.

“Targeting can be thought of as tilting, tilted again.”Just as smart beta strategies sought to replace replicating indexes by “tilting” to a certain factor, targeted funds with conviction are likely to deliver outperformance and appeal to investors who value “indexing’s virtues,” the columnist wrote.

“Targeting can be thought of as tilting, tilted again,” Rekenthaler continued. “[It] can be considered as hyperactive management, implemented mechanically.”

According to the column, tilting significantly reduces the number of stocks considered for a portfolio, but also retains hundreds.

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“Tilting is a strategy that comes from the academic community, based on the research of comprehensive databases, ad is intended to be applied very broadly,” Rekenthaler wrote. “Professors are cautious. When professors play the odds, they want the law of large numbers on their side.”

And this idea has been successful. Smart beta funds make up 12% of indexed mutual and exchange-traded funds, representing half a trillion dollars in assets.

“Tilting has moved well beyond cult status,” the columnist said. “The approach is here to stay.”

However, taking smart beta and applying investment managers’ conviction would result in a more concentrated portfolio of stocks—as few as 50.

Referencing investment manager Patrick O’Shaughnessy, Rekenthaler explained target indexes begin with zero in each stock, not with the market weight. This would likely result in higher active share as well as potential for alpha.

This targeted approach would result in the best possible factor combinations for outperformance, as well as lower expense ratios than traditionally managed indexes, he added.

“Targeted funds will be made for the times,” Rekenthaler concluded. “I think it will become an established method by which funds invest.”

Despite two high profile divestments, US public pension funds remain committed to hedge funds, research has shown.

According to a Preqin analysis, 282 public pensions are currently invested in hedge funds, an increase from 276 in 2015 and 269 in 2014. An additional six funds are considering their first allocation to the investment vehicle, Preqin reported.

Pensions plans are also investing more in hedge funds, Preqin found, growing their allocations from 7.2% of their total portfolios in 2010 to 9.2% in 2016. Current investments in hedge funds by public pensions total $310 billion—nearly 10% of all hedge fund capital.

Additionally, more than a quarter of hedge fund managers said they have at least one public fund among their investors.

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“There are more US public pension funds investing in hedge funds than ever and these pension funds are dedicating ever growing portions of their portfolios to the investment class,” said Amy Bensted, head of hedge fund products at Preqin.

This is in spite of decisions to exit hedge funds by the $296 billion California Public Employees’ Retirement System (CalPERS) and, more recently, the $55 billion New York City Employees’ Retirement System (NYCERS).

NYCERS, which has been invested in hedge funds since 2010, voted this month to liquidate its $1.7 billion allocation “as soon as practicable” due to “exorbitant fees” and underperformance.

While Preqin found “widespread levels of dissatisfaction with hedge fund performance”—approximately one-third of institutional investors said their hedge fund portfolio disappointed expectations in 2015—public pensions were not driven away.

Instead, 93% of pension funds increased or maintained their allocations in 2015, compared to 2014. Just 7% invested less capital in hedge funds.

The Teacher Retirement System of Texas was the largest allocator to hedge funds, with a $15 billion commitment out of the total $125 billion portfolio, according to Preqin. The $90 billion Ohio Public Employees’ Retirement System followed suit with a $13 billion allocation.

Other large hedge fund investors included the Florida State Board of Administration, New Jersey State Investment Council, and New York State Common Retirement Fund.

public pension hf Source: Preqin’s “US Public Pension Funds Update”