UK National Pension Combines EM with Smart Beta

The UK’s national defined contribution (DC) pension plan has added to its emerging market offerings and hosted a smart beta fund on its investment platform in its first foray into alternative indexing.

The National Employment Savings Trust (NEST) has chosen funds managed by HSBC Global Asset Management and Northern Trust to access emerging market economies.

The HSBC fund uses an alternative index lens while the the Northern Trust fund uses an environmental, governance, and social screen.

“This is our first exposure to alternative indexing and reflects two of NEST’s investment beliefs that indexed management, where available, is generally more efficient than active management and that integrating valuation considerations into the investment process can enhance our long-term performance,” said Mark Fawcett, CIO of NEST.

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“Indexed management… is generally more efficient than active management,” Mark Fawcett, CIO, NEST.

“We want to capitalise on growth and rewarded risk no matter where it is in the world and these emerging market mandates give us greater control of our exposure to this important asset class.”

The plan already has exposure to emerging markets through a BlackRock fund, while investors will access the two new offerings through a blended approach.

NEST said the move provided “greater flexibility” for its “dynamic risk management approach”.

The scheme was launched to coincide with mandatory auto-enrolment of the majority of UK workers. It is expected to be one of the world’s largest DC plans, eventually growing to manage tens of billions of pounds for the country’s workforce. It is a multi-employer, low-cost plan that is available to the several million-strong labour force.

Last year, Fawcett told Chief Investment Officerabout its plan to “recycle” illiquid assets held on the platform between maturing cohorts and those remaining in the fund.

An S&P Dow Jones Indices director has argued that the Vix index is far higher than “realised” volatility—but the ride will get rougher in the next few months.

The VIX index, which measures market volatility, is actually much higher than the current levels being demonstrated in the S&P 500 index, according to S&P Dow Jones Indices.

Tim Edwards, director of index investment strategy at the company, said the VIX’s current measure of roughly 11.5 was nearly double the 6% annualised volatility actually registered by the S&P 500.

“Although the VIX is a measure of implied, rather than actual, volatility, it still ought somehow to be anchored in realised volatility data,” Edwards said.

“The VIX is currently much, much higher than realized volatility. One interpretation of this is that the market ‘expects’ next month’s volatility to be nearly double what we’ve seen recently. Moreover, the futures market is pricing in an expected gain in the VIX to around 17 by March 2015—nearly triple the current level of realized volatility.”

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Edwards argued that the discrepancy between the two measures was down to the VIX pricing in tail risks that the S&P 500 was not. “The mere possibility of tail events—invisible in current equity valuations—provides the VIX with a different perspective,” he said.

Janet Yellen, chair of the US Federal Reserve, warned last month that ultra-low volatility in markets could “induce risk-taking behaviour that entails excessive buildup in leverage or maturity extension”, which could in turn pose risks to financial stability.

But while the discrepancy between the S&P’s volatility and VIX’s reading exists, Edwards warned that strategies for making money remained risky and “exclusive to the courageous”.

“Selling S&P 500 put and/or call options can realise a profit if volatility proves less than expected, as can taking short positions in either VIX futures or in related exchange-traded products,” he said. But “the risks of such strategies are far from symmetric”, he added: Any unforeseen event to introduce volatility to the market could cause massive losses for any investors who short VIX futures.

Edwards concluded: “Even when profit is possible, or highly likely, dramatic risks remain. Selling volatility remains a strategy exclusive to the courageous. Perhaps that is one reason why the Vix is so high.”