Case Studies: LPP and FRR
Charlotte Moore outlines how two pension funds are using factor-investing strategies
Local Pensions Partnership
• Location: Preston, Lancashire and London.
• Collaboration between Lancashire County Pension Fund and London Pensions Fund Authority
• Assets: £2.2bn (€2.6bn) in internal equity portfolio
• Members: 241,000
Even though Local Pensions Partnership (LPP) is in its infancy – it was formed in April 2016 when the London Pensions Fund Authority set up a joint venture with the Lancashire County Pension Fund – it has strong views on the importance of factor investing.
That is despite the structure of the fund bringing some complications to implementing a factor-investing strategy. Max Townshend, investment director at LPP, says: “The LPFA and LCPF remain as ‘sovereign clients’.” LPP undertakes regular asset allocation reviews to assist clients in determining their target portfolio.
LPFA and LCPF’s portfolios are currently divided into eight different asset classes: listed and private equity, fixed income, credit, real estate, infrastructure, total return and cash. Townshend says: “Each client establishes a tolerance range for asset allocation along with a central target.”
As the portfolio is divided between asset classes rather than investment factors, allocations to investment factors have to be managed within an individual asset class.
“That means we have to monitor our overall exposure to a particular investment factor at scheme top-down level, as the allocations are made in each individual asset class,” says Townshend.
While this constrains how LPP can allocate investment factors, it does not exclude this type of investment strategy. For example, the fund has an explicit quality bias in its long-equity portfolio, despite the overall beta of this portfolio being close to one.
The equity portfolio is benchmarked to the MSCI World index. Townshend says: “We expect this portfolio to have a similar risk to the index but for returns to be higher.”
Rather than implement this bias through a systematic fund with a quality tilt, LPP uses internal and external active managers. Townshend says: “The fund includes systematic as well as discretionary managers but they are all actively managed strategies.”
Townshend says it is difficult to find a systematic, rules-based product that matches LPP’s approach to the quality investment factor.
For example, it is impossible to find parameters which identify competitive advantages or whether a company’s abnormal cash flow generation is durable. Townshend says: “There is a lot of value in these relatively hard-to-define factors and current alternative beta funds struggle to capture this efficiently.”
The fund is considering adding other investment factors to its equity portfolio. Townshend says: “We may soon, for example, add a value manager, as we have not been exposed to this investment factor for some time.”
LPP also allocates to investment factors its other liquid portfolio – its total-return allocation. This multi-asset fund uses a cash benchmark. The fund is equity market neutral and principally invested in liquid alternatives.
This fund can be used to balance factor exposure, says Townshend. “If the equity portfolio has a significant quality bias and a distinct view on factors like value, then what other factors are most beneficial to the total return portfolio?”. It would not make sense, for example, for the total return fund to have a large exposure to a quality-equity factor as the fund would then be over-exposed to that particular strategy.
Townshend says: “We could still have an allocation to quality in this part of the portfolio but we would be cognisant of the exposure of the overall portfolio.” While the asset allocation decisions made in the total-return portfolio are shaped by the equity portfolio, equity allocations are made without consideration of the total return portfolio.
To ensure the overall fund portfolio is diversified across a number of different factors, there is a significant allocation to trend-following – or momentum strategies – in the total return allocation across multiple asset classes, including equities, FX, rates, credit and commodities.
Townshend says: “We use a number of different strategies to get this exposure.” Unlike the equity portfolio, this fund includes a mixture of active and more passive, alternative beta, strategies.
For example, this fund has three different momentum managers, all of whom are systematic investors. Townshend says: “One aims to generate additional returns so could be a considered a more actively managed fund.” But other funds are more akin to a classic alternative beta fund with a low fee rate. He adds: “We view this as a trend-beta factor fund.”
LPP has allocated to different types of systematic momentum managers to ensure the portfolio is sufficiently diversified across a continuum of actively and passively managed funds. Townshend says: “We aware of the quant blow-ups over the course of history, so we do not want to be over-exposed to one particular investment style.”
But these allocations are under review. Townshend says: “Over the next 12 months we will be re-vamping those total return allocations. We are looking at a range of alternative sources of risk premia.”
The FRR Pension Reserve Fund is as a public administrative establishment created by law.
• Location: Paris
• Net assets: €36bn (31.12.16)
The Fonds de Réserve pour les Retraites (FRR) was ahead of the curve in that its smart beta journey can be traced back to 2009. Olivier Rousseau, a management board member, says: “Our first foray into factor investing was a tactical decision to invest in a fund following the RAFI index.”
This investment decision was shaped by the restrictions made on the fund: it cannot own stock directly; and it has to give mandates or invest in funds. The FFR made its RAFI allocation to increase the beta of the equity portfolio and to outperform the market as its performance started to recover after the global financial crisis.
Rousseau says: “It made sense to use an index with a higher beta than the cap-weighted index as the market started to recover. It was a tactical play.”
The RAFI index does not aim to exploit a particular investment factor directly. The index was designed as way to avoid the pitfalls of a classic market-capitalisation index, by weighting stock allocations according to other metrics. But this design gives it an effective bias to the value-investment factor. Rousseau says: “It’s a value index in disguise.”
This strategy was a success and encouraged the fund to move towards factor investing. “At the end of 2011, we invested in minimum-volatility strategies in Europe and North America,” Rousseau says.
The allocation was made to reduce risk and in particular to minimise exposure to the banking sector because the fund was concerned about these stocks. “But our timing was off – we missed the bottom of the market,” he says.
Rather than just using alternative indices tactically, FFR started to consider using these indices for a more strategic asset allocation. Rousseau says: “We recognised that we could collect the risk premia associated with different investment factors over a full market cycle with better risk metrics.”
To implement this approach, the fund allocated funds to four different indices – a low-volatility index, an EDHEC risk-efficient index as well as a risk parity index into addition to the RAFI index. Rousseau says: “We liked the maximum diversification of the EDHEC index and the new generation of risk parity indices.”
He adds: “We combined these four indices into an equal-weighted composite, which rebalances back to 25% every three months.” The rebalancing occurs on the same date to take advantage of internal crossing, which reduces the transaction costs.
While these four indices can be defined as alternative indices – they weight their stocks according to metrics other than market-capitalisation – only one deliberately targets an investment factor: the low-volatility index.
But just as the RAFI index is essentially a value index, other alternatively weighted indices give greater exposure to the size investment factor by including a larger proportion of small caps than a traditional index. Rousseau says: “The maximum diversification index also gives exposure to the low-volatility factor.”
In 2015, FFR reviewed its asset allocation and noted that the low-volatility factor had “performed outrageously well since the global financial crisis”, says Rousseau. “Much of this performance could be attributed to many of the low-volatility stocks acting as bond proxies and their defensive characteristics,” he adds.
It had become a self-reinforcing trade: investors’ appetite for these stocks steadily increased, which both increased their valuations and further lowered their volatility. As interest rates reached very low levels and premiums for these stocks ratcheted upwards, it was obvious that additional returns would be unlikely.
In contrast to the heady performance of low volatility stocks, the underperformance of the value factor had reached historic level, when taking account of both the magnitude and the duration of the underperformance.
“In July 2016, we decided that we should allocate new funds to a value strategy.” As well as increasing its allocation to the RAFI index, the fund had also developed an index with MSCI which combines value and momentum,” Rousseau says.
“We wanted a fund that exploited both value and momentum factors because these investment factors are usually uncorrelated and sometimes even negatively correlated.” In addition, the fund lacked exposure to the momentum factor in its other asset allocations.
The fund could have chosen to use an active manager rather than an index to achieve its exposure to value and momentum, says Rousseau. “The academic research shows that in efficient markets, almost all of the benefits of appointing an active manager can be achieved by using factor indexation, so it makes sense to use the cheapest implementation.”
There is a concern that the underperformance of value will persist as long as quantitative easing persists. But the improving economic outlook for the euro-zone makes it more likely that value should outperform over the medium term.
Rousseau says: “Assuming the European elections go smoothly later this year, it is more likely that economic momentum will pick up, which increases the chances of the ECB raising interest rates.” In this environment, value factors should keep outperforming while low volatility indices will struggle.