Views & Innovations

How smart beta can help
DC schemes

May 3, 2016

"Smart beta” has almost as many definitions as there are people who use the term. Let’s begin, then, by specifying what we at BlackRock mean by it. “Smart beta” investment strategies utilize economic insights to systematically screen widely-used indexes and benchmarks to capture broad, persistent drivers of returns other than market capitalization (the total value of all shares in a company).

For instance, one of the most common investment vehicles is an equity index fund—a fund that pools shares of all the companies on a given index (say, the FTSE 100) relative to each company’s market capitalization. The more an individual company is worth, the greater will be its share of the fund relative to the others on the index.

A “smart beta” fund might include those same 100 companies, but weigh them in a different way—for instance by the dividends they pay or by the historical average of their volatility, to name just two of the other “factors” beyond market cap by which companies can be selected and ranked. No longer, then, is the largest company by market cap on the index necessarily the largest single component of the smart beta fund. Depending on the factor chosen, that company might actually not be included at all. Smart beta strategies may then be most simply understood as ways to seize time-tested investment opportunities by looking beyond market cap.

It should go without saying that investors aren’t necessarily looking to invest in the biggest company. They’re looking for the best possible returns, consistent with the level of risk they’re comfortable taking and that is appropriate to their life circumstances (income, consumption habits, years until retirement, and so on). Smart beta could help generate those returns.

As with any investment, there are no guarantees that smart beta strategies will deliver on their intended outcomes. That said, smart beta could be attractive to defined contribution (DC) plan sponsors and trustees—to those who set up and oversee pensions and choose the investments—for a number of reasons.

First and foremost, smart beta potentially offers better outcomes than purely passive investment strategies, depending on what the client is seeking to achieve. With passive investing, there are no teams of human researchers actively picking individual companies or other assets. Pure passive investing funds mimic the composition of existing indexes. Thus the investor’s returns should simply be as high or as low as the market itself, with only a small difference owing to the cost of the investment itself. Smart beta, as noted, looks beyond traditional indexes to other factors—such as value, quality, and momentum—that have the potential to generate returns above market averages or to take on lower-than-average risk. Although, as with nearly all investments, there’s no guarantee that a smart beta portfolio will outperform a traditional index fund.

Second, smart beta strategies can be effective at delivering clear investment outcomes—and not just in terms of performance but also, for instance, in seeking to reduce risk—in a transparent way. Smart beta investment selections follow pre-set rules to determine what assets to include, how to construct portfolios, and how and when to rebalance them. These rules are often published by a third-party provider and made available to investors.

Several research projects into consumer attitudes of long-term saving behaviors show that when plan participants feel they don’t fully understand how their money is being invested, a sense of fear and suspicion can result.1 The ability to deliver a high level of transparency helps plan participants feel more connected to their retirement savings. While information will not necessarily boost understanding, the increased transparency around how a strategy is built and could perform in various markets can enable investment managers to improve their communication around potential DC plan outcomes.

Several research projects into consumer attitudes of long-term saving behaviors show that when plan participants feel they don’t fully understand how their money is being invested, a sense of fear and suspicion can result.1 The ability to deliver a high level of transparency helps plan participants feel more connected to their retirement savings. While information will not necessarily boost understanding, the increased transparency around how a strategy is built and could perform in various markets can enable investment managers to improve their communication around potential DC plan outcomes.

Third, smart beta is very cost-effective. While active management can produce superior returns, the research component is necessarily expensive, which boosts fees. Smart beta funds function somewhere between active and passive. They are passive in that there are no human researchers actively choosing investments. But smart beta captures some of the benefits of active funds in that specific investments are selected for specific reasons, only instead of the selections being made individually, they are made automatically by selecting for various factors. This process of automated asset-picking typically makes smart beta funds on average slightly more expensive than purely passive funds, but usually significantly less expensive than active.

All of this is true of smart beta generally. What differentiates BlackRock’s approach is the way we connect smart beta strategies to what we call “lifecycle investing.” Put as simply as possible, for the purposes of investing, a person’s adult life may be grouped into three phases: accumulation, pre-retirement, and retirement. Each carries a unique investment objective, requiring specific types of investments to meet the ultimate goal, which is to retire with financial security.

Broadly speaking, younger investors with decades before they retire need to take on more risk in order to maximize the “time value” of their money—that is, money’s potential to earn greater returns over longer periods of time. Investors close to, or in, retirement require the opposite: less risk and more certainty.

Smart beta could help. For instance, younger investors could consider single or combined factors—so-called “multi-factors”—that seek higher returns are selected. For older investors, the factors could shift toward seeking to minimizing volatility and aiming to maximize stability and predictability.

The chart below illustrates how the mixture of share-based smart beta factors, and hence assets in an investor’s portfolio, changes as retirement approaches:

Factors in Life Cycle Investing

Many readers will see at a glance that this looks a lot like the glidepath (the way the asset mix changes over time) of a target date fund (TDF)—a fund that automatically reduces risks and rebalances as the investor ages. That’s no accident. Both are essentially trying to solve for the same problem: securing the appropriate level of risk and return relative to the investor’s years until retirement.

As the inventor of the TDF, BlackRock naturally believes that it offers an ideal solution to many investors and plan sponsors alike. But as the chart above shows, there’s more than one way to achieve the same goal. “Life-styling” investing accomplishes much the same, just using a different product and process. But whether through TDFs or through lifecycle investing, smart beta strategies can move investors from more risky assets to less risky assets as they approach retirement.

To test the potential benefits of smart beta investing, we ran a series of analyses that compared the actual performance of certain market cap indexes over a hypothetically-constructed working lifetime to the performance, over the same period, of smart beta portfolios made up of the same investments but weighted by factors other than market cap. In all cases, the smart beta portfolios outperformed the traditional indexes. A detailed write-up of our findings is currently in review with an international academic journal.

DC plan members—and sponsors and trustees—face complex, dynamic, and multi-faceted challenges. Early in the accumulation phase, the main focus is on growth and ways to preserve it. Approaching retirement and post retirement, the main considerations are typically to concentrate on the stable income that a plan member’s savings can support. These challenges are top of the agenda of plan sponsors, consultants, managers and providers alike who are looking for ways to deliver better value to members and potentially influence their behavior throughout their retirement journey. Our research shows that product innovation, including smart beta applied to lifecycle investing, can potentially be an effective next step in exploring new ways to deliver value to members.

About the author

Manuela Sperandeo
Director, BlackRock
Manuela Sperandeo, Director, is EMEA Head of Specialist Sales for EII, responsible for the distribution of Smart Beta, ESG and Liquid Alternatives ETFs. Prior ...