The 0.75% charge cap is forcing DC schemes to be creative in their investment strategy to generate adequate returns for members. One possible approach is factor-based investing, writes Michael Klimes
- There are costs constraints around DC investments
- Old passive approach with bonds and equities will no longer generate sufficient returns
- Factor-based investing could generate higher returns for a reasonable price
Trustees and managers in defined contribution (DC) plans are under pressure to ensure members get a good and steady return within the 0.75% charge cap. Pension pots have also been affected by historically low interest rates and further quantitative easing (QE). These conditions make it more difficult for some schemes to take a more aggressive investment approach.
However, there is method used in defined benefit (DB) arrangements that some DC schemes are beginning to consider. This is known as factor-based investing, which HSBC is thinking about introducing in its £2.6bn DC fund, having found the strategy to work well in its DB scheme.
HSBC Bank Pension Trust chief investment officer Mark Thompson explained why at the Legal and General Investment Management (LGIM) annual DC conference on 14 September. "There is more cost pressure in DC but factor investing could allow some of the benefits that come from active management to be used in DC in terms of the upside of riskier investments."
What is it?
A BlackRock seminar on 13 September compared factor-based investing to the more traditional approach of mixing equities and bonds in balanced funds.
There are two sets of factors the fund manager uses for factor-based investing. The first is 'macro factors', which look at common return drivers across asset classes. These include economic growth, credit, inflation, real rates, liquidity and emerging markets.
Here the perspective is more of a bird's eye view of investment. BlackRock believes these six factors explain 95% of returns across multiple asset classes. It thinks portfolios should be designed with exposure to these factors through diversification.
The second group are 'style factors', which examine what has delivered returns over the long term within asset classes. Here the fund manager's behaviour is more tactical and categories include value, momentum, quality, low volatility and size.
BlackRock EMEA head of investment strategy David Gibbon explained the underlying philosophy. "The way we approach market advantage is by turning the asset allocation question around. We don't try to figure how much capital we should allocate to different classes but how much risk we should allocate to the drivers of return. Factor-based investing takes technology and greater availability of data to apply these factor insights to get a better strategic allocation and appreciation of risk."
Old vs new
Factor-based investing has a number of advantages compared to traditional balanced funds. Both the macro and style factors offer fund managers alternate tools to construct better portfolios.
The definitive difference between macro factors and traditional use of equities/bonds is diversification. "We want to ensure we have the right level of diversification among these macro drivers of return. Doing that ensures we can target this more attractive risk-adjusted return compared to what the traditional balanced funds have achieved historically," said Gibbon.
Furthermore, in a period of economic uncertainty macro factors can exploit opportunities that an old-style portfolio cannot. "When growth is on the downside there are simply not enough drivers of return during the weaker period. Economic growth still matters," said Gibbon.
"It is one of the most important factors and attracts a third of the risk capital in our portfolio but we want to achieve a better balance among the other five [macro factors]. When growth disappoints we have other risk factors that can pick up the pieces when returns are disappointing."
While the macro points are prominent they are complemented by the style factors.
For instance, the volatility factor is used to smooth any risk that might emerge in the asset classes that are invested in, while quality, size, momentum, and value are there to enhance returns. The theory goes that style factors can align the types of investment with the needs of savers more than traditional methods.
Gibbon said: "For younger investors who are targeting higher returns, a multi-asset approach balances risk against these factor-based styles. Over time that moves to a risk-mitigating strategy like minimum volatility for older investors. We think there are loads of good things in factor-based investing that can enhance DC strategies."
When factor-based investing works it is meant to yield superior rewards. "The results can be better investment outcomes, enhanced returns, lower risk or better diversification. It is also a better way to apply a lens on active managers to understand what the drivers of returns you are paying for actually are."
This is echoed in comments by HSBC's Thompson, who argued it produces superior returns compared to just looking at market capitalisation.
BlackRock EMEA head of diversified strategies Adam Ryan said trustees should think of better ways of building market exposure rather than simply buying indices.
"In that way you can bring the cost down and still have a lot of value in asset allocation within in the fund."
Ryan went on to explain what his firm has done in fixed income. "In bond markets if you simply buy the index, the biggest component is the biggest debtors; that is not always the best way to invest in fixed income markets. The way we have indexed the fixed component of this is working with some of our quant teams within BlackRock to reduce the weighting to some of the biggest issuers in the indices. Instead we have more weight towards some of the higher quality or smaller issuers within that index."
This more adroit approach and cost pressure in DC makes a move towards factor based investment likely, according to LGIM head of DC Emma Douglas (pictured above). "It has to be the way ahead for DC with the charge cap. We are in a cost constrained environment but are we happy with just market cap weighted indices? Can we do better than that? I think it [factor-based investing] gives you the opportunity to get higher returns without having to pay full active fees."
As schemes grapple with the charge cap, more innovative ways of investing in DC are likely to capture the ear of trustees in search of solutions.
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