smart beta

Smart beta in DC plans

Insight from BlackRock’s Sara Shores
Mar 29, 2017 / By BlackRock

Factor investing is growing in popularity among institutional portfolio managers - 87% of whom report using factor analysis in making investment decisions.1 And now we are beginning to see growing interest in factor investing and smart beta among defined contribution (DC) plan sponsors.

For insight into smart beta and its possible role in DC, we spoke to Sara Shores, the Global Head of Smart Beta for BlackRock.

Let’s start with a definition: What is
smart beta?

Sara Shores: Smart beta is the long-only, index-driven form of factor-based investing. It begins with the traditional cap-weighted index and tilts towards factors that have been persistently rewarded over time such as minimum volatility, value and quality.

Factors are not new. They have been well understood by the marketplace for many decades. They have historically been implemented by active managers and, in years past, often required unique access, sophisticated technology and a lot of data that wasn't widely available. What is new is the advancements in data and technology that allow us to access these same time-tested ideas in a more transparent and rules-based form, generally at a lower fee than traditional active management.

What is driving interest in
smart beta?

Shores: We believe there is a role for passive, active and smart beta strategies in DC investment menus and solutions. The right combination of the three will vary based upon the risk, return and cost requirements of the plan. That said, we believe true alpha can only be delivered by a skilled active manager. Investors are increasingly factor aware – evaluating active strategies net of what can be delivered through smart beta. I think there's been an increasing interest in static tilts towards factors like value or momentum that can be delivered through low cost and transparent smart beta strategies.

Why is that of interest to DC
plan sponsors?

Shores: Well, I think that there are a couple of trends that are particularly germane to DC. We continue to see downward pressure on management fees across every part of the investment industry. Smart beta has the potential to provide a cost effective source of return that can complement market beta and true alpha, aiming to lower costs and improve diversification.

Another key trend is the industry consensus that we are facing an extended low return environment. If that’s the case, market beta may not get participants the returns they want. We need to harvest many potential sources of return.

What are smart beta strategies
that a DC plan sponsor might want
to consider?

Shores: We have two flagship strategies: Minimum Volatility (Min Vol) and Diversified Multifactor (DMF). Min Vol seeks market-like exposures with less risk, and seeks to provide downside protection when equity markets struggle. DMF is the other side of the coin: It seeks to outperform the broad market with a similar level of risk.

How does DMF seek to
deliver outperformance?

Shores: The name diversified multi-factor says it all: It’s designed to provide diversified exposure across many factors, namely value, quality, momentum and size. Diversification among lowly correlated factors is like diversifying across securities or asset classes. We want to blend them together to seek a better and more consistent outcome.

There's some important nuances in the way that we construct the diversified multifactor index. It's meant to be a core replacement. We want the basic shape of that portfolio to be similar to a broad cap weighted index, by which I mean I want things like the sector allocations to be roughly the same, with a tilt towards those securities that are smaller, inexpensive, trending and have strong balance sheets.

Does one factor take preference
over the other if there are
competing characteristics?

Shores: No. In DMF, we don't favor one factor versus another. The four factors are all roughly equally weighted in our evaluation of each security. Apple, for example, gets a score for quality, a score for value, a score for momentum and a score for size. We equally weight the four scores to give us an aggregate score for Apple.

We believe providing an aggregate score and constructing a single index from the bottom up is significantly more efficient than the more simplistic approach of combining four single-factor strategies. It’s one optimization rather than four standalone indexes that are duct taped together. If I'm only evaluating securities on the basis of value, I'm going to pick the ones that are the least expensive. But some of those are cheap for a reason. If I'm only evaluating securities based upon the quality of their balance sheet, I'm going to find ones that have really strong earnings, but some are going to be really expensive. But, if I'm simultaneously evaluating securities to find ones that look like they have a good balance sheet and are relatively inexpensive compared to peers, I am more likely to get a stronger, more efficient portfolio.   

Do you want to touch briefly on
Min Vol?

Shores: The portfolio construction process for DMF and Min Vol is very similar. We constrain the country and the sector weights to be similar to the parent cap weighted index, but tilt towards the lower risk stocks. An optimized portfolio means we take into account information on correlations as well: We're not looking for a collection of the lowest volatility names; we’re looking for the lowest volatility portfolio.

The importance of sector neutrality has been highlighted in recent months. The expectation of yield steepening has led to a rotation out of more defensive sectors, including utilities, telecoms and REITs. Sector neutral versions of Min Vol can help mitigate the potential drag of rising rates on excess returns, as sector weights are constrained to be similar to that of the broad market index.

Is DMF or Min Vol exposure used in your target date products?

Shores: They both are. The glidepath seeks to maximize returns through higher equity exposure in a participant’s early career, and shifts toward fixed income strategies as they move toward retirement. Smart beta gives us an opportunity to reinforce that shift by overlaying a glidepath inside the equity/bond glidepath that seeks to take advantage of factor insights.

A simple way to understand it is that the traditional glidepath tells us which asset classes to invest in, while the smart beta glidepath tells us which securities to buy. In other words, the traditional glidepath determines a mix of asset classes to match the risk level indicated by the lifecycle model. We use the smart beta glidepath to look inside asset classes through a factor lens to determine how to implement the asset class investment. Early in the glidepath, we use a diversified multifactor exposure that seeks to enhance returns. Later we shift increasingly to a Min Vol exposure to seek to control volatility near and through retirement.

Does this change the risk or equity
levels in the glidepath?

Shores: We take the beta of the traditional glidepath determined by the LifePath model as a given, and then optimize the mix of DMF and Min Vol exposures to match the equity beta. Early in the glidepath, the result is more return potential for the same level of risk. Later in the glidepath, we can actually have a higher equity landing point because Min Vol exposures have generally had a lower beta than the cap weighted index. The result is higher return potential within retirement, without increasing the risk.