Northern Trust: Popularity of Passive Investing Fuels Customized Beta Strategies

(March 6, 2012) — The growing use of passive investing strategies among institutional investors is fueling the popularity of customized indices to meet fund objectives, according to a new survey by Northern Trust.

In the survey, 40% of institutions globally identified customized beta as being relevant to their current portfolio construction models. Meanwhile, 51% said they would be interested in exploring customized indices as a way of addressing their objectives. However, only 22% have evaluated customized beta approaches.

In terms of the popularity of passive investing, worldwide, approximately one third of all institutions surveyed by Northern Trust said passive products makes up more than 40% of their equity and fixed-income assets today. Despite this continued trend toward allocating to index strategies, 63% of all participating institutions said that known inefficiencies should be addressed and removed, with one in five saying they would be willing to pay for this service.

The global survey was conducted of 121 institutional investors, predominantly pension funds, in Europe, Asia and North America, representing more than $500 billion in assets.

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The report on the study — titled “Customized Beta: Changing Perspectives on Passive Investing” — investigates the attitudes of institutional investors at a time when turbulence and uncertainty have put a spotlight on risk management. “The research highlights how the increased use of passive investing is leading to a blurring of traditionally-held views on the separation of alpha and beta, as more choices exist for investors within the spectrum of beta,” Northern Trust stated in a release.

“Investors around the world are reframing their thinking about their funds’ objectives, with an overwhelming 84% from our survey saying that meeting their investment objective is more important than outperforming a benchmark,” said John Krieg, managing director, asset management, Europe, Middle East & Africa region, Northern Trust.

Institutional investors surveyed by Northern Trust cited a range of benefits derived from customized beta strategies. While European respondents view such strategies as having the potential to increase transparency, and as an effective screening tool to meet socially responsible investing and environmental, social and governance investment objectives, Asian respondents see customized beta strategies as a way to eliminate methodology- and weighting-based biases from standard indices. Meanwhile, North American respondents consider customized beta strategies as a means of gaining exposure to new markets.

The heightened focus on passive investing was also revealed in a survey conducted last month by Keefe, Bruyette & Woods (KBW). According to the firm — which questioned approximately 42 decisionmakers at corporate and government pension plans, endowments, foundations, and investment managers in order to garner insight into institutional investors’ asset allocation and manager selection process — respondents generally expected to increase their allocations to passive and alternative strategies. In particular, respondents seemed interested in various hedge fund strategies and specialized strategies, such as real estate, energy, and infrastructure.

(March 6, 2012) — The United Kingdom Government could cause a ‘flash crash’ in June, should it liquidate a certain section of the Royal Mail Pension Fund portfolio it is set to take over later this month.

The pension fund portfolio contains £2.7 billion in UK equity futures, classed as a ‘return-seeking overlay’, according to its latest annual report. These futures are due to either roll over in June, as has been the case for the past couple of years, or be liquidated.

The £2.7 billion figure is equivalent to around 7.5% of the UK FTSE futures market, according to data from Bloomberg this morning.

Market analysts said this figure would be equal to around 80% of an average day’s trading volume on the FTSE100 and could have a dramatic impact on the market if liquidated.

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An investment banking analyst said: “Using our Market Impact model and simulating the sell of the underlying cash we would expect an impact cost of around 2%. This trade as a percentage of the average daily volume (ADV) of each stock represent 80% of the ADV so a careful execution of that trade would be needed to minimise its impact.”

According to Bloomberg, the market capitalisation of the entire FTSE index was around £1.65 trillion this morning. Using these calculations, unwinding these positions in June could have a £16.5 billion impact on the UK equity market.

The government is set to take control of the pension fund’s assets, which belong to the legacy public sector company, this month once a hurdle set by the European Union has cleared the path for transferral. The Government will then be responsible for paying the members’ pensions.

In autumn last year, the Office for Budget Responsibility commented on the £25 billion in potentially transferred assets: “There is significant uncertainty over the timing, nature and size of the corresponding transactions, with the proposal still subject to state aid discussions. However, there are potentially very large fiscal implications, for example public sector net borrowing (PSNB) may be reduced by around £25 billion in the year the transaction takes place.”

If the Treasury is to take over the portfolioit will have to decide what to do with the futures contracts. If it rolls them over for another year, it risks political backlash should the UK equity markets fall and result in a derivatives loss; but if it unwinds the positions, there is a risk of a ‘flash crash’ as the UK stock markets would be flooded with unwanted futures positions.

Since June 2011, these futures would have so far produced a 1.6% return, according to Bloomberg.

A panel of transition managers has been appointed, but not yet named, by specialist firm Inalytics to transfer the assets of the pension fund into government accounts. No detail has been given on the terms of their mandate.

In this month’s magazine, aiCIO revealed the Royal Mail Pension Fund had been overcharged by State Street for its transition management work last year, which led to a refund by the bank and the dismissal of two of the department chiefs.

There is precedent by the UK government to sell down pensions assets it has taken on. In 2004, the Treasury assumed the liabilities for the nuclear industry, and with it took over the £4 billion Nuclear Liabilities Investment Portfolio (NLIP) from British Nuclear Fuels (BNFL).

Following this move the treasury liquidated the portfolio of managed funds and index-linked gilts in two stages, according to the Government’s Debt Management Office (DMO). The first part was to liquidate managed investment funds, and redeem one of its index-linked gilts in December 2006. The remaining £1.8 billion of index-linked gilts were sold in May and June of 2007.

A Department for Business, Innovation and Skills spokesperson said: “At this stage we are not able to comment on the level of assets transferring to Government. However we will look to realise all assets in a measured fashion whilst seeking to avoid any market distortion.”

The Royal Mail Pension Fund declined to comment.