Doing it all with beta

The last five years has seen something of a revolution within defined contribution (DC) investment and, in particular, default funds.

A new breed of investment was in the ascendancy, with diversified growth funds (DGFs) offering trustees and employers access to low cost growth assets that were more diversified than the small number of funds they might be running.

That is, until the charge cap was introduced.

The charge cap of 75 basis points (bps) for default funds has already had a major impact on DC investments.

Many scheme have already wound down their exposure to certain DGFs, as they fear breaching the cap. This means ‘dialling down’ the investment strategy with an increase of passive investments, with or without some active management at some point of the process.

Though there is an increased use of passive in both the UK and Europe, this is a long way from a “wholesale shift”, says Tim Huver, product manager at Vanguard.

“There are active/passive combinations being used, sometimes for specific tilts or over weights. However, when we talk about the spectrum of beta, what we are seeing is a greying of that spectrum between passive and active.”

And with good reason. Even before the charge cap was introduced, many schemes had already been increasing their passive allocations as part of their de-risking strategy. It was a similar tactic in areas where they felt they could not find active managers who could outperform or which were new to them.

ALTERNATIVE SOLUTIONS

Turning down the wick by moving towards a fully passive default may satisfy the charge cap, but it won’t necessarily deliver members with sufficient growth to deliver them a meaningful income in retirement. So why don’t DC funds look to hedge funds and other alternatives as a portion of their default funds?

Well, some probably do, but while adding them may improve portfolio efficiency – the return for a measure of risk – they are sold on the basis of skill, and as a result attract a premium. They can’t therefore make it under the charge cap.

Phil Irvine, director, PiRho Investment Consulting, says: “For skill based liquid strategies, a number of academics over the years have claimed that most of the return of hedge funds has come from their exposure to alternative risk beta.”

These risk premia include:

• equity returns – small cap outperforms large cap, value outperforms growth, momentum, quality;
• merger arbitrage – premium priced into the target stock until the deal completes;
• convertible bond arbitrage – buying mis-priced convertible bonds and shorting equity exposure of the bond; and
• asset allocation – seek to ‘back out’ the asset allocation of successful macro hedge funds.

“In a number of cases, the same academics have ‘assisted’ the investment industry to replicate or reproduce hedge fund returns in a systematic manner, often using exchange traded, highly liquid derivatives,” says Irvine.

“The claimed advantages of these funds are transparency, liquidity, no capacity constraints, no manager specific risk and cheapness.”

This move to capture the beta within the risk factors active managers are exposed to has resulted in another investment revolution – what many call ‘smart beta’ products.