Smart beta

The smart beta opportunity for
target date funds

May 15, 2017
By BlackRock

Using smart beta strategies within a target date fund glidepath has the potential to capture persistent return factors exposures to drive additional return or reduce risk at specific points on the glidepath.
Here’s how it works.

What role can smart beta play in
target date funds?

On an intuitive level, incorporating smart beta indexes into the glidepath as a substitute for cap-weighted indexes is attractive. In addition to potentially improved returns, smart beta offers the possibility of favoring certain factors or collections of factors at specific points along the glidepath to help reinforce its management of risk and return during the lifecycle.

Yet, we have seen a reluctance by plan sponsors to incorporate smart beta strategies in target date funds, in part, we believe, because their high level of fiduciary responsibility for participants makes many understandably reluctant to look beyond more familiar cap-weighted index strategies.

However, factor insights have a track record within institutional plans.1 Smart beta portfolios are often highly diversified and can be constrained to maintain a portfolio shape similar to the familiar cap-weighted index – yet they have the potential to increase diversification by taking a more granular economic and investment style examination of risk and return.

Ultimately, we believe that incorporating smart beta into a target date fund may help improve its ability to achieve participant retirement objectives and represents a potential advance in target date fund construction. Below, we explore how a potential smart beta glidepath may be constructed.

How to build a smart beta glidepath

First we need to consider which factors or combination of factors may help target date funds meet their objectives.

Individual factors like value, size, momentum and quality each have a long history of delivering excess return over the long run.2 But they may have short-term cycles during which they may underperform – periods when, for example, momentum may underperform while value provides strong returns. So combining many factors may provide a more consistent return stream over time than an individual factor.

When implementing smart beta within a glidepath, we can begin with the cap-weighted index and screen for the factors or combination of factors we want to emphasize to design a portfolio with the same basic shape as the cap-weighted index, making operational implementation in place of a cap-weighted equity index straightforward. Below, we evaluate three possibilities.

Example 1: Seeking return enhancement

Icon: Seeking return enhancement

We know that value, quality, momentum and size factors have historically been associated with market outperformance. The MSCI Diversified Multiple-factor (DMF) index is a diversified index that includes exposure to all four factors, which could potentially seek return enhancement, while maintaining a level of risk that’s comparable to cap-weighted indexes.

Example 2: Seeking reduced volatility

Icon: Seeking reduced volatility

The versatility of smart beta strategies can be seen in the MSCI Minimum Volatility (Min Vol) index. Similar to the DMF index, the Min Vol index is also designed to have the same broad market characteristics as the respective cap-weighted index, making it suitable as a core part of equity allocations. But while the DMF Index is designed to outperform with similar risk, the Min Vol index is intended to deliver market-like returns with less risk.

Example 3: Seeking fixed
income diversification

Icon: Seeking fixed income diversification

We believe the next frontier for smart beta is fixed income. Many of the same style factors observed in equities, such as value and quality, also tend to drive returns for fixed income securities.

One potential approach for capturing fixed income factors within a glidepath’s bond allocation is to use a well-diversified fixed income smart beta index based on the Bloomberg Barclays Fixed Income Balanced Risk (FIBR) indexes (specifically the Bloomberg Barclays Constant Weights index in this family) as a core replacement for the Bloomberg Barclays U.S. Aggregate (the Agg).

Bringing it all together: The smart
beta glidepath

Based on the examples above, the goal of the smart beta glidepath is to:

  • Tilt the equity allocation towards a DMF index to seek enhanced returns when investors are young.
  • Shift equities from the DMF Index exposure to a Min Vol index as investors move closer to retirement.
  • Use a fixed income smart beta index, such as FIBR, to seek potentially increased diversification benefits (and higher Sharpe ratios) compared with the Agg or other market capitalization-based fixed income indexes.

Conclusion

The factors that smart beta seeks to identify and emphasize have a long track record of academic research. They represent a new execution of an investment philosophy that was once accessible only to active managers, but can now be applied through low-cost index-based strategies. We believe incorporating smart beta potentially improves a target date fund’s ability to help achieve its retirement objectives. For that reason, we believe that target date funds incorporating smart beta are the next generation of the target date fund evolution.

For more on approach and implementation, read the full paper.

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