Defined Contribution

Smart beta in DC plans

Jul 5, 2018
By BlackRock

Factor investing is not a new addition to the investing world—it has been a mainstay of institutional investing for decades.i While factor insights are well established, advances in data and technology have increased the availability of data and the ability to meaningfully analyze it – making the implementation of factor insights more cost effective and brought factor investing to wider range of investors.

And that has caught the interest of defined contribution (DC) plan sponsors. We spoke to Sara Shores, the Head of Investment Strategy for the Factor-Based Strategies Group at BlackRock, for insight into how factor investing, particularly through smart beta implementations, can be used in DC and target date funds.

Let’s start with a basic question: what’s the difference between factors and smart beta?

Sara Shores: Factors are not new. They have been well understood by the marketplace for many decades. They have historically been implemented as a part of actively managed strategies 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.

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.

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 will be facing an extended low return environment. If that’s the case, market beta alone 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 believe investors should have exposure to a variety of factors in their portfolio. That’s why we seek to gain exposure to factors in multiple asset classes, including both defensive factors—such as minimum volatility and quality, and more risk seeking factors—such as momentum or size. In equities, we offer two flagship smart beta strategies to harvest factor returns: 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 four 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 the DMF index is constructed to ensure it is well diversified. 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 – with roughly the same sector or regional exposures -- with a tilt towards those securities that are smaller, inexpensive, trending up, and have strong balance sheets.

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

Shores: No. In DMF, no one factor is favored over another. The four factors are all roughly equally weighted in the 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, which are equally weighted to give us an aggregate score for a portfolio optimization.

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. The country and the sector weights are constrained to be similar to the parent cap weighted index, but tilted 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.

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

Shores: They both are. We emphasize return seeking equity factors in a participant’s early career and defensive equity and fixed income strategies as they move towards retirement. This is essentially a glidepath within the glidepath: the equity/bond mix becomes more conservative as investors near retirement, and so too do the factor exposures within each asset class. 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 favor increased exposure to strategies that seek to enhance returns, examples include DMF and a multi-factor high yield strategy. Near and through retirement, we shift to more defensive strategies to provide the potential for more downside risk protection, employing strategies such as Min Vol in equities and a multi-factor investment grade credit strategy.

The target date funds also have an allocation to the Total Factor Fund. Can you describe its role?

Shores: Total Factor Fund (TFF) is BlackRock’s best ideas factor fund—it extends style factors around the world and across asset classes, investing both long and short. TFF is diversified across stocks, bonds, currencies and commodities, tilting into those markets that are lower risk, cheaper, trending and offering higher yields. In other words: TFF targets value, momentum, carry, low volatility, and quality across equities, equity markets, fixed income currencies and commodities. Combining many factors across many markets, TFF is both diversified – targeting many sources of potential return – and diversifying – with a low correlation to the core stock/bond portfolio.

Now let’s put that in a target date context. With its balanced, multi-asset structure, the Total Factor Fund aims to provide returns on par with equities, but far more diversified with many sources of potential returns. TFF also seeks to provide more diversified sources of safety. Investing in global sovereigns and inflation linked bonds, these ‘safe’ assets in TFF are more diversified than a U.S. Aggregate exposure. Further, its exposures to low volatility and quality also provide sources of defensive equity returns. This makes TFF particularly attractive for the retirement vintage. We allocate to the fund across the glidepath, and increase the allocation towards retirement to take full advantage of its potential.

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

Shores: We build upon the flagship, research-driven glidepath of the LifePath® series, seeking to improve risk adjusted returns by introducing factor strategies—while maintaining roughly the same amount of equity and fixed income exposure at each point in the glidepath.

Do you also take a factor approach with the fixed income allocation?

Shores: Many of the same factors investors are familiar with in equities—value, momentum and quality—are also present in bond markets: cheap bonds tend to outperform expensive peers, recent trends tend to persist, and higher quality companies tend to outperform junk. Investors also benefit from investing in bonds with higher levels of income, a concept commonly known as carry. These are the same concepts we apply in equities and other asset classes, but we also need to recognize what makes bond markets unique. Perhaps most importantly, bond markets are inherently asymmetric: the best a bond can do over its life is pull to par but the worst is can do is default. This means that avoiding those potential defaults is the most important aspect of security selection.

What strategies are employed to capture these fixed income factors?

Shores: LifePath makes use of two enhanced credit strategies—one in investment grade and the other in high yield—that leverage the proprietary default models of our active fixed income teams, screening out those issuers with the highest probability of default. These measures of default form our measures of quality, which are combined with a value measure to weed out the issues that are too expensive. The combination of value and quality seeks to deliver a corporate bond portfolio that is defensive with an attractive level of income.

The Total Factor Fund also invests in a global universe of sovereign bonds, emphasizing those that are inexpensive (value), trending (momentum) and with attractive levels of income (carry). Combined with the enhanced credit strategies, the resulting fixed income exposure is highly diversified in sector, geography and factor exposures providing a diverse source of potential income and safety for target date investors.