Fonds de Réserve pour les Retraites (FRR), France, Olivier Rousseau, Executive director
• Location: Paris
• Assets: €37bn
• Funding ratio: 149%
• Reserve fund for the French pension system
We made a strategic decision to invest in smart beta indexes at a strategic level, to target a moderate but robust outperformance, as we believe there are certain markets where it’s difficult to get sustainable alpha through active fundamental management. The smart beta investments focus on the euro-zone and North America and represent 24% of our developed-country equity portfolio (excluding cash equitisation futures) and 42% of passive equity mandates.
We favour value, small-cap and low volatility as factors, as we see evidence that they are systematically rewarded. We are more prudent about momentum, but nevertheless we are still planning to insert an element of ‘momentum plus value’ in our portfolio. Naturally, the more low-volume tilts you introduce, the more you reduce the beta in your portfolio, which means you get penalised when markets rise. We have tried to reduce the amount of unwanted bias in our portfolio by combining four different FTSE smart beta indices and creating a composite index, also calculated by FTSE. The four indices are FTSE Minimum Variance, RAFI QSR, Edhec-Risk Efficient and FTSE Equal Risk Contributions.
Every quarter the indices are rebalanced internally, but we also rebalanced the weight of the indices to the original 25% contribution. This helps limit turnover costs, as a stock may exit an index but enter another one. We chose this strategy because we believe there is no superior weighting scheme. It reduces the risk that our smart beta strategy will severely underperform at any point. Combining these four betas into one single composite index has provided more robust alpha, and the cumulative outperformance since 2002 is strong, reaching 55% and 70% the in euro-zone and the US respectively (including the effect of reinvestment of outperformance in rising markets).
We still believe there are some markets where it’s more natural to look for alpha, because they are inefficient and under-researched. The European and French small-cap markets, as well as the Japanese market, are two examples. In a somewhat counterintuitive manner, we have invested actively in the large and mid-cap American market, allowing our manager to tilt the portfolio to small caps or value if they see fit. It is possible to find alpha, even in the most efficient markets, but it takes a good manager with a substantial style bias.
National Employment Savings Trust (NEST), UK, Mark Fawcett, CIO
• Location: London
• Assets: £528m (€740m)
• Membership: 2.3m
• UK government-backed defined contribution master trust
We do not like the term ‘smart beta’. We prefer ‘alternative indexing’, as a more accurate and less loaded term. NEST made its first allocations to alternative indices through two emerging market equity mandates last year. The two funds are the HSBC Global Investment Funds (GIF) Economic Scale Index GEM Equity fund and the Northern Trust Emerging Markets Custom ESG Equity Index fund.
These funds were both relatively new and innovative when we procured them and we were among the first investors. The two offer different but complementary strategies. HSBC uses a fundamentally constructed index, which will benefit from both rebalancing and from having a consistent value tilt. While the MSCI custom index that the Northern Trust fund tracks is weighted on a market-capitalisation basis, we believe the ESG [environmental, social and governance] screening will improve the risk characteristics of the portfolio. With one fund having a value bias and the other having a momentum bias, there will be times when one outperforms the other, but we believe there are additional benefits from systematically rebalancing between the two.
We have an investment belief that indexed management, where available, is generally more efficient than active management. In practice, this means we will only seek active management where we believe it can add value, improve risk management or indexing is impractical. Currently, our active management is focused on direct real estate, corporate bonds and money markets. We are passively invested in global developed equities, global REITs [Real Estate Investment Trusts] and government bonds. We see alternative indexing as somewhere between the two. It has many of the efficiencies of passive management but the choice of index is an active decision.
We have a rigorous manager and fund selection process that includes gaining a thorough understanding of the index construction methodology. As part of our risk-management process, we obtain portfolio holdings from the managers on a regular basis, so we get very good transparency. We have an ongoing discussion with our managers about implementation, particularly as in emerging markets foreign investor access to shares is not always straightforward.
Universities Superannuation Scheme (USS), UK, Elizabeth Fernando, Head of equities
• Location: London & Liverpool
• Assets: £49bn (€67bn)
• Membership: 147,137
• Pension fund for the UK’s higher-education sector
We have two smart beta equity portfolios. The first is our sustainable income portfolio, launched in December 2013. It has an allocation of £445m (€626m). The second is our low-volatility factor portfolio, which went live in mid-July this year with an allocation of £250m (€352m). In total, these two strategies represent around 3% of our £21bn (€29bn) equity allocation.
Traditionally, pension funds have made large beta allocations on the basis that they have long horizons, so they can afford to ride out short-term volatility in equities, while eventually outperforming bonds.
The great advantage of factor portfolios is that you can design their indices to clearly align with the pension fund’s objectives. The role of the sustainable income portfolio is to provide a rising real income stream to pay our pension obligations, while remaining affordable to our members.
Most of USS’s equity investments are actively managed in-house. A decision to allocate to a factor or smart beta portfolio is an active decision as we are expressing a belief that the return and risk characteristics we will secure from it are preferable to those we would secure from the market portfolio.
The benchmark for the sustainable income portfolio was built by the investment committee and the USS Investment Management Board. The low-volatility portfolio benchmark was designed with FTSE, allowing us to assess not only whether the decision to allocate to the low-volatility factor was a good one, but also whether our internal team is adding value in implementation.
We believe factor portfolios work best if you combine a systematic quantitative approach with qualitative investment insights that the model cannot capture. We leverage the significant expertise of our active in-house managers to give us this edge.
Ideally, we need a 10-year track record, and five years at a minimum, before we can be confident that the returns are a product of the design of the strategy rather than luck. If the portfolios continue to behave as we expect them to we will continue to gradually increase our allocation. We are already committed to investing another £250m (€352m) in our low-volatility portfolio in six months’ time and are re-examining the sustainable income quantitative process to make it more automated, allowing us to implement a much larger allocation.
Interviews conducted by Carlo Svaluto Moreolo