Swiss pension funds have mostly shied away from alternatively weighted benchmark strategies. Cécile Sourbes finds that adoption will depend on thorough analysis and transparency of data
Attempts by some of the world’s largest banks to fix the LIBOR rate has high-
lighted the need for transparency and integrity in the calculation of benchmarks. But it is the lack of flexibility to move from one benchmark to another, as well as the calculation method used to launch such indices, that worries Swiss pension funds more.
As Frédéric Arthur Dodard, head of the Paris investment solutions group at State Street Global Advisors (SSGA), said at the PPS conference in Lausanne last month, many Swiss funds are reviewing their choice of passive benchmark. “However, this also raises the question of choosing the right asset allocation when the strategy is initiated and of reviewing it once it has already been implemented,” he told delegates.
Dodard says Swiss pension funds have recently expressed their concerns about the lack of flexibility offered by index providers when a scheme decides to shift benchmarks halfway through its asset allocation strategy. According to Françoise Bruderer, managing director of the Swiss Post scheme, pension funds have often found support from asset managers and index providers when they start an investment strategy or look for new benchmarks. “But they are too often left alone when it comes to change benchmarks,” she says.
Pension funds, asset managers and index providers all agree that adjustments are necessary over time as benchmark selection can represent an extra source of return. But, in practice, the cost associated with rebalancing and the willingness of asset managers to conduct the analysis required to do so often creates barriers for pension funds to change benchmarks.
Pension schemes often choose performance benchmarks on the basis of the advice and analysis received from asset managers, Claude Schafer, director of the Caisse de Prévoyance de l’Etat de Fribourg (CPPEF) argues. Even though indices are “indispensable” when it comes to defining a new investment strategy, Schafer says pension funds often lack the necessary knowledge and internal resources to assess benchmarks.
“I believe the responsibility for selecting the right benchmarks lies with asset managers,” he says. “Although the management board of the CPPEF has a responsibility, to us, benchmarks are nothing less than a barometer for monitoring our investments.”
One of the major concerns for pension funds is the calculations underpinning benchmarks. If performance of benchmarks were a given pre-2007-08, the crisis compelled Swiss pension funds to take into account the importance of careful analysis of composition and weighting methodologies.
Proponents of alternative index methodologies believe that traditional cap-weighted equity indices tend to overweight overvalued securities and underweight undervalued ones.
But analysis is required, more so because the use of alternative benchmarking and sometimes more complex index strategies by pension funds is increasing, although take up has been slow.
A study conducted by Bfinance in March 2012 predicted pension funds would focus more on ‘smart-beta’ investment strategies as they look for higher returns in core portfolios. At the time, the consultancy said that one-third of the 82 European institutional investors responding to the survey would devote over 10% of their portfolio to smart beta by 2015.
In its Global Investment Matters 2013 report, Towers Watson conceded that smart beta requires more governance than assets such as equities and bonds. “This requires expertise in understanding strategies, risk and position sizing, and monitoring,” the authors write. “However, diversity with smart beta might be a good governance budget spend for investors with moderate capabilities.”
In Switzerland, using alternative benchmarks remains limited. Some pension funds, as well as asset managers, are reluctant to adopt a smart beta approach, asserting that their costs remain high and that these strategies have often underperformed. However, some investors are changing their minds about smart beta.
During the 2008-09 downturn, many funds were disappointed that active equity managers did not provide downside protection and produce better returns than indices. Providers of smart beta indices argue that these instruments will perform better than market cap-weighted indices, or provide a better risk/return ratio.
Those criteria appeal to many Swiss pension schemes. Bruderer, for instance, explains that the Swiss Post fund has been looking into smart beta strategies since the crisis. However, she insists this implies a “major cost increase” for the fund looking to select the right benchmark.
That is certainly the reason why many of her counterparts are still reluctant to undertake such a move. For the CPPEF, it is not time to shift to smart beta indices, although things might change in the near future once a new investment strategy is introduced, Schafer concedes.
Beyond the question of costs lies the issue of performance. As Noël Amenc, director at EDHEC-Risk Institute says, index providers traditionally justify the use and costs of alternative benchmarks by claiming they outperform cap-weighted indices. “But, investors should be aware that smart beta benchmarks can also have periods where they underperform,” he says.
“As a result, investors should have access not only to the performance data provided by index providers but also to the risks to which those indices are exposed,” he adds.
While Amenc recommends that pension funds should conduct a thorough analysis of each smart beta index, Bruno Maumené, managing director and COO of the Lausanne-based risk management firm Fundo, says pension funds should also exert more pressure on index providers with a view to increasing benchmark transparency.
“Pension funds should urge index providers to offer more transparency on the companies they include in their benchmark,” he says. “For instance, nobody seems to know on what criteria companies included in the S&P 500 index are selected. The main challenge for investors is to get access to effective benchmarks, which will, in turn, limit rebalancing costs when they wish to move from an index to another.”