PENSIOEN PRO PARTNER ROUNDTABLE
Beta-plus: enhanced indexing 2.0
Much has changed since the early days of factor investing and ‘smart beta’ strategies, and today interest in enhanced indexing is on the rise again. What does the new batch of beta-plus strategies look like? How do they differ from the previous generation, and what do they have to offer pension funds – now, during, and after the transition to the new system?
The Pensioen Pro Partner Roundtable on enhanced indexing began by looking at how far the twin trends of ESG and systematic investing are fusing in Dutch pension fund portfolios. Jaap Hoek, head of investment strategy and solutions for Russell Investments in Northern Europe, noted that investing by factors such as Value and Momentum came from an academic background. Now such quantitative strategies include more and more ESG components as more data becomes available.
Hoek warned, however, that some of these new strategies rely on data mining. He said that Russell’s Dutch clients were not using enhanced indexing currently: “We use quant managers with really active high tracking error.”
Gerco Goote, fiduciary management director of MN, declared himself a huge fan of enhanced indexing. “We like rules-based indexing, which leads to a conscious and transparent selection of companies within the portfolio,” he said. “This creates a narrower benchmark, which is easily replicated.”
MN’s first generation of these portfolios was devised in 2018 and predicated on exclusions. The second generation, co-created with MN’s biggest clients, the metal industry’s two pension funds, PME and PMT, went live earlier this year. The major difference was that version two began with investment beliefs and is predicated on inclusions. Risks are comparable to the broader benchmark and tracking error to the broader benchmark is low. “Our clients are happy because it’s explainable and transparent,” noted Goote.
Dennis Thé, head of quantitative investment strategies at Achmea Investment Management, said his team uses the benchmark as a starting point and enhances exposure by adding factor tilts: “Therefore, it’s deemed enhanced.” For Thé, the real difference since 2000 has been the growth of ESG. “I agree with Gerco that ‘inclusions’ are probably the biggest trend, moving away from merely excluding companies from the investment universe.”
Thé’s concern was what happens when the new pension contract takes force. “If the retail investor is going to determine the market demand, then perhaps there will be more demand for different products than enhanced indexing,” he said.
Key topic for the coming years
René Rijk, investment manager at Pensioenfonds Horeca & Catering said the fund has no exposure to enhanced indexing, preferring basic passive in Developed Markets. Because Pensioenfonds Horeca & Catering is increasingly incorporating exclusions, however, it is heading towards the limits of what is possible in a purely passively managed mandate. Tracking error is already above 1%, in part due to targets for CO2 reduction. Going forward, accommodating Sustainable Development Goals preferences might have impact as well.
Claus F. Nielsen, lead portfolio manager on the Beta Plus strategy at Nordea Asset Management, returned to Hoek’s point regarding data mining. “It’s extremely important to avoid big risks around ESG generating alpha. Some of that premium is explained by the flows towards ESG stocks.”
Nielsen said that Beta Plus looks to Value and Quality, blending in ESG as a factor. “We look at correlations, but hopefully not in a data-mining way. Value and Quality are still driving factors. An index is the cheapest format [to realise such a strategy].”
He added that when you have to increase ESG, you have to change the benchmark but the benchmark is changing all the time anyway. He said that compared to active management, enhanced indexing saves something on the cost side. Then there is the possibility of a positive return – Beta Plus has averaged 1% gross of fees with 1% tracking error since inception in 2016. In one calendar year only it has underperformed the index. “You get something, but have to pay a little more in risk and fees,” said Nielsen.
Ronald van Dijk, CIO of Pensioenfonds Rail and OV, said enhanced indexing is a key topic for the coming years. “Pension funds are going for comprehensive ESG programmes and low-cost solutions. Combine this with massively powerful technology and you get some opportunities in all kinds of products, tilted on liquidity, performance and risk profiles.”
Importance of ownership
Van Dijk noted that in the past pension funds would look to a preferred single manager to provide all the components of an enhanced index solution, whereas now the solution can be based on a series of providers excelling in an individual discipline: ESG data; risk modelling; index calculation; factor modelling. “They can be combined in one integrated package, for example by the fiduciary. Because you can shop around, a best-of-breed solution can be constructed instead of relying on a single vendor suite.”
Nonetheless, Rijk queried who is going to act on behalf of mid-sized pension funds in all these multiple negotiations.
Hoek warned that pension funds must remain the owner “because with all these combinations, you might have a sub-optimal outcome.” He recalled widespread disappointment with factor investing. “The lesson learned is to make it explainable,” he said.
“Value and Quality are still driving factors.” Claus F. Nielsen, lead portfolio manager on the Beta Plus strategy at Nordea Asset Management.
Van Dijk said that you could build the index with the help of your preferred index provider and your preferred ESG data providers at reasonable cost; then integrate systematic alpha from, let’s say Achmea, on top to create the index that is replicated by your favourite portfolio manager. So, each component of the final index solution is integrated on top of a previously constructed auxiliary index. This sequential approach creates transparency and facilitates return and risk attribution.
Nielsen warned there was a risk that you don’t have control of the final outcome if you tilt to one outcome. He gave his version of the three dimensions to modern investing: risk control, alpha and green tilt.
Data cost and quality still an issue
Nielsen was asked whether the Beta Plus could be customised to accommodate individual clients’ special wishes. “That would be nice but still a bit expensive,” he replied. “If you can come with the relevant data, it might work but we need the same data on every constituent in the index.” He noted that data are still expensive and on some measures, patchy.
Van Dijk agreed that the quality of ESG data leaves a lot to be desired: “Asset management is 70-80% data management and sustainability is a rather new industry.” He added that AI companies can extract ESG from other sources using innovative technology: “The number of niche providers that can offer interesting insights using AI is rapidly growing.”
With quality data so expensive and hard to come by, the question arises why pension funds don’t club together and pool resources in sourcing information.
Rijk responded that pension funds are at different stages of adoption. Goote and Nielsen both suggested that even a few big pension funds are not that much of the entire buying market and so it would be hard to convince any provider to collaborate with them in a special arrangement.
“We have 20 people processing ESG-related data on companies,” said Nielsen. “Lots of managers have that but the crucial thing is whether I want more. I’m not sure it’s worth it.”
Focus on ‘ESG alpha’
MN’s Goote gave some more insight on the effort and time required: “We made a two-year programme with our clients. For each model we asked what data are available? How can we have impact on the portfolio?” He said that now the portfolio can be adjusted at any time.
Hoek applauded that MN does the calculations itself rather than leaving it to underlying managers. “You, the fiduciary, make a portfolio so the manager can follow it.”
Goote explained that MN’s current strategy does not have alpha generators.
Hoek asserted that when you deviate from the market, then you have investment beliefs. In that sense MN combines alpha with beliefs.
Goote replied that there was ESG alpha: “We do that and we stop there.” He said that PME, for example, wants a more concentrated portfolio but predicated on conscious selection. “The third-party asset manager can only choose from the Conscious Selection index. PME is going focused but not to chase financial outperformance. The long-run return objective is the same as the market cap index.”
Achmea has done something similar for clients, focusing on performance similar to the standard MSCI ACWI but taking into account client-relevant ESG characteristics using an ESG-factor. The investment universe has something like 250 names, selected by the client. The actual portfolio has around 100 names. Tracking error against the parent MSCI index is not relevant. “Now ESG is of more importance, not alpha,” summarised Thé.
What about costs?
Goote drew attention to rebalancing costs. In MN’s original version stocks were coming in and out in strict accordance with the exclusions criteria. In the second version, there is a grey area, acknowledging that the effects of ESG criteria wax and wane even within the same calendar year. The slower approach has lowered turnover.
Rijk nevertheless pondered whether, in the world of Dutch pensions where every euro of cost gets scrutinised, bespoking was worthwhile.
Goote replied that the uptick in costs was negligible compared to passive management fees. He said it was fractions of a basis point more than passive for a big pension fund, adding that MN has a string of smaller funds who benefit from this product without having to contribute governance resources to its development.
“Rules-based indexing leads to conscious and transparent selection of companies,” Gerco Goote, fiduciary management director of MN.
Thé said there was wiggle room for pension funds in negotiations with third parties. In spite of the concentration of assets in the top five funds in the Netherlands, he said that index providers and asset managers would still consider the likes of Pensioenfonds Horeca & Catering as a big fund.
Enhanced indexing versus smart beta
So how does the new Enhanced Indexing differ from factor investing, aka smart beta in version 2.0? Nielsen said that some factor investing didn’t have control of the model. “There were Value traps,” he warned. “You should buy Value and Quality stocks. Then add on Growth as a measure.”
Factor investing is not new and overexploiting of the standard academic factors is a risk. More than 20 years ago Van Dijk oversaw quant equity teams that managed active equity products exploiting Value, Quality and Growth. He considers an index model plus factors as almost the same as an active strategy based on an alpha model. Van Dijk told the panel that what has changed over the years is how modern factor investing (version 3.0) uses much more data to generate signals. The models changed from simple formulae and a few databases to highly computer intensive techniques to create insight from text, audio and a large variety of massive databases. He agreed that best practice is now data-driven. “Data management should be a key skill of each manager,” he said.
Goote said that MN stopped with factor investing soon after the Global Financial Crisis. Regarding modern factor investing, Goote said it is too opaque for our clients.
Nielsen felt that Artificial Intelligence is very interesting. His prime concern, however, was that with €50bn in assets under management to invest, any new ideas generated by AI could cause market impact.
Regarding salient factors, Nielsen suggested that they can be exploited in many ways. Nordea tries to distinguish itself by concentrating on the recommendations only of the top 25% of analysts. “From the old factors we have generated more than 50 bps annualised,” he observed.
Then there are modifications based on experience. For example, in the IT sector Value does not work.
Waiting for diversification
The conversation shifted to the dominance of the ‘Magnificent Seven’ in U.S. equities. Thé reckoned that market concentration explains to a great extent why factor investing has a more difficult time beating the market.
Nielsen suggested that greater diversification will re-assert itself but had no idea when.
Goote recalled that MN’s first-generation enhanced indexing set a maximum weighting for any stock at 1% of the portfolio. “That was painful as Big Tech has outpaced others in terms of market capitalisation – but we still outperformed,” he told the panel. “In our second iteration, we raised the maximum weighting to 3%, more from a risk perspective.”
The power of co-creation
Goote said the first lesson learnt from conscious selection was that if you are not sure, better to do half than nothing. The second was to increase pension funds’ sense of ownership of their portfolios. “We are there because of the clients, not the other way round. By walking the path together, pension fund boards are deeply involved in the process.”
Thé said there were challenges in that respect. “The boards of pension funds change. New people bring new ideas. The strategy needs to become embedded into the DNA of the pension fund, its practices and memory, not just the personnel as they may change.”
Goote agreed that the people should not matter. “That is why co-creation is such a powerful way of ownership.”
Looking ahead
Looking to the future, Nielsen said these are early days for assessing a company by ESG criteria. “I hope in the EU we will get more decisive about which companies are not investing properly. At the moment it is not standardized. When we get more uniform, that will be good for companies because they will change behaviour. It will be clearer to see who are the good guys and who are the bad guys.”
Hoek said the new pensions contract is a challenge for the boards. “I don’t expect participants to query the board’s investment decisions straightaway but down the line, in several years’ time, I do see challenges, especially in the flexible contract.”
Goote added this might erode support for ESG. “Participants haven’t seen asset management results against their name before,” he said. ‘When they do, and see the results fluctuate over time, some may demand their pension fund focus just on financial results alone. We will need to be able to explain the added value of ESG investing.”