Smart Beta Investing in Dc

MAX FACTOR SMART BETA INVESTING IN DC Factor investing, or Smart Beta, is providing a BY SOPHIE BALLARD, SENIOR DC RELATIONSHIP MANAGER new frontier for DC schemes to address a range of investing needs. Improved diversification and better risk-adjusted returns, together with the cost-efficiency and transparency characteristics of index investing, are key attractions.

ather than simply weighting stocks by their market cap, as is done in index investing, Smart Beta is changing the investing landscape. And DC investors Rare catching on. Compared to market cap-weighted benchmarks, these factor-based strategies give schemes the opportunity to target higher returns over time, lower risk, or a combination of both, using cost-efficient implementation approaches.

Targeting factors in this way allows schemes to seek the underlying drivers of investment return that were once the sole preserve of active managers. Smart Beta effectively combines some of the benefits of both active and index management. Predictable exposures and straightforward implementation can also help to reduce the governance burdens on DC scheme management.

12 Contribute Autumn 2017 State Street Global Advisors Integrating Smart Beta into DC Schemes There are a number of ways Smart Beta can be used in DC. CHOOSING FACTORS Strategic implementations can introduce factors either alone or in combination. Looking at past performance, Smart Beta strategies target a range some factors are more pro-cyclical, i.e. they tend to do of factors including: better in stronger, positive markets (Value, Small Cap), Value stocks trade at a lower price than while others are more defensive (Low Volatility, High VALUE their fundamentals (earnings, sales Quality). Smart Beta is often a complement to traditional etc.) would imply. Inexpensive stocks index strategies — so an analysis of the wider portfolio have been shown to out-perform more can help to align the portfolio to the scheme’s goals, expensive stock over time. existing holdings and constraints. Regardless of the intended objective, it’s crucial to remember that the best risk-adjusted returns are achieved from long-term exposures and that patience Smaller-cap companies have tended to SMALL CAP outperform larger-cap companies over is necessary to get the best from factor investing. the long term.

Target Improved Risk-adjusted Returns

We know from our research that DC members generally value a smoother investment journey. When Smart Beta strategies that target Quality or Low Volatility factors are Tilting towards lower risk stocks introduced, they can help to lower overall volatility and LOW can generate improved risk-adjusted limit the impact of market falls, at relatively low cost. VOLATILITY returns. Many Low Volatility indices attain a 20–30% reduction in Multi-factor funds that combine a number of Smart volatility, compared to their Beta factors can help the scheme to diversify even cap-weighted indices. further and take advantage of low or negative correlations between factors. Combining the Quality and Low Volatility factors, for example, can build a defensive allocation that complements value-based strategies. Such an approach might be adopted if the Investing in higher-quality companies QUALITY (high profitability, earnings stability, portfolio already has exposure to Value or if a more low leverage etc.) has been shown to conservative investment approach is preferred. deliver greater downside protection. Combining factors in this way can help dampen In falling markets their stock price the cyclical effects of Smart Beta and offer schemes tends to be less impacted than the overall market. a potentially smoother risk/return profile compared to single-factor exposures.

Refining the Glide Path Glide Path Asset Allocation

Target Date Funds have the ability to continually evolve 0% Bonds and utilise new investment ideas, such as Smart Beta. DGF The growth phase of their glide path can, for example, invest in Value and Small Cap factors, then transition to Quality and Low Volatility strategies as the fund matures and looks to derisk. Multi-factor A larger allocation is made to Value or Small Cap factors early in the investment glide path in order to target 50% improved risk-adjusted returns. As retirement nears — and members’ ability to Passive equity sustain losses reduces — Low Volatility or Quality factors are progressively introduced to narrow the volatility profile further. This approach helps optimise allocations throughout 100% the lifetime of the scheme — more return-seeking assets 40 35 30 25 20 15 10 5 0 earlier in the glide path, less volatility towards retirement. Years to retirement

Source: SSGA 2017. For illustrative purposes only.

ssga.com/ukdc 13 SMART BETA IN THE DC schemes describe their decision to implement Smart Beta as part of their INVESTMENT TOOLKIT investment strategy. CASE STUDY 1 CONSUMER Scheme size £50M GOODS 2,500 MEMBERS

What type of factors are you targeting In essence, the strategy is passively managed with a Q with Smart Beta strategies? set of rules regarding stock weightings. It targets particular stock characteristics like low valuation We are targeting Value, Size, Quality companies, which outperform over the longer term and Low Volatility. — which is relatively intuitive for members. Communications are similar to those for passive Is this replacing or complementing a market investing — the fund is a passive fund, which means cap approach? Q that the shares are chosen in such a way as to track a It is replacing our market cap allocation. broad index of shares in a mechanistic manner rather than relying on a particular investment What attributes of the approach make it manager to individually choose shares. Q attractive for your plan/strategy? What do you see as the potential benefits for • Access to fundamentally desirable members over the long term? characteristics such as Value Q Higher net risk-adjusted returns in the growth • Higher expected risk-adjusted returns compared phase that will contribute to better member with market cap passive investing outcomes at retirement. • Avoiding biases associated with market cap investing such as placing higher weight to the most expensive companies Smart Beta Essentials 1 = not important, 4 = essential • Adding value through sensible annual rebalancing

• Similar charges to passive market cap investing

How are you communicating with members Q about Smart Beta? Governance Cost We recommended the Global Multi-Factor Strategy within a blended fund, combining an allocation to an Emerging Markets Index Fund.

Factor Return targeting potential Diversification

14 Contribute Autumn 2017 State Street Global Advisors CASE STUDY 2

Scheme size ENGINEERING >£1BN 30,000 MEMBERS

What type of factors are you targeting What do you see as the potential benefits for Q with Smart Beta strategies? Q members over the long term? Fundamental indexation and Low Volatility. From an investment perspective, Smart Beta provides diversification from traditional equity Is this replacing or complementing a market exposure with improved long-term risk/return. Plus, Q cap approach? it offers reduced fees for members and lower governance needs for trustees. As a complement to existing market cap index strategies within our default investment option. Smart Beta Essentials What attributes of the approach make it 1 = not important, 4 = essential Q attractive for your plan/strategy? It introduces an element of diversification away from a pure market cap equity strategy. It’s expected to modestly improve the risk/return profile for a member over the long run, without compromising on overall returns. The lower fees and governance Return Diversification requirements (relative to an active equity strategy) potential also appeal as a DC investor.

How are you communicating with members Q about Smart Beta? The Smart Beta funds are wrapped within a white-labelled fund. Members will see they hold Factor Governance targeting Cost units in a single fund which has an objective to deliver long-term growth that is similar to equities but with less variability in returns.

NEXT STEPS To learn more about the potential of Smart Beta for your scheme, visit the Smart Beta section of our website.

ssga.com/ukdc 15 CONTRIBUTE For subscriptions, email us at [email protected] or visit ssga.com/ukdc

Marketing Communication Risks associated with equity investing include stock values which may Belgium: State Street Global Advisors Belgium, Chaussée de La Hulpe 120, 1000 fluctuate in response to the activities of individual companies and general Brussels, Belgium. T: +32 (0) 2 663 2036. SSGA Belgium is a branch office of State market and economic conditions. Street Global Advisors Limited. State Street Global Advisors Limited is authorised Bonds generally present less short-term risk and volatility than stocks, but and regulated by the Financial Conduct Authority in the United Kingdom. contain interest rate risk (as interest rates raise, bond prices usually fall); Dubai: State Street Bank and Trust Company (Representative Office), issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These Boulevard Plaza 1, 17th Floor, Office 1703 Near Dubai Mall & Burj Khalifa, effects are usually pronounced for longer-term securities. 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All material has been obtained (Sede Secondaria di Milano) is a branch office of State Street Global Advisors from sources believed to be reliable. There is no representation or warranty Limited. Street Global Advisors Limited is authorised and regulated by the as to the accuracy of the information and State Street shall have no liability Financial Conduct Authority in the United Kingdom. for decisions based on such information. Netherlands: State Street Global Advisors Netherlands, Apollo Building, The whole or any part of this work may not be reproduced, copied or transmitted 7th floor, Herikerbergweg 29, 1101 CN Amsterdam, Netherlands. or any of its contents disclosed to third parties without SSGA’s express written T: +31 (0) 20 718 17 01. SSGA Netherlands is a branch office of State Street consent. Investing involves risk including the risk of loss of principal. Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Past performance is not a guarantee of future results. Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Diversification does not ensure a profit or guarantee against loss. Zurich. T: +41 (0) 44 245 7000. Authorised and regulated by the Eidgenössische A Smart Beta strategy does not seek to replicate the performance of a Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce specified cap-weighted index and as such may underperform such an index. Zurich CHE-105.078.458. The factors to which a Smart Beta strategy seeks to deliver exposure may United Kingdom: State Street Global Advisors Limited, 20 Churchill Place, themselves undergo cyclical performance. As such, a Smart Beta strategy Canary Wharf, London, E14 5HJ. T: +44 (0) 20 3395 6000. Authorised and may underperform the market or other Smart Beta strategies exposed to regulated by the Financial Conduct Authority. Registered in England. similar or other targeted factors. In fact, we believe that factor premia accrue Registered No. 2509928. VAT No. 5776591 81. over the long term (5-10 years), and investors must keep that long time horizon in mind when investing. Branch office websites: www.ssga.com Low volatility funds can exhibit relative low volatility and excess returns This communication is directed at professional clients (this includes eligible compared to the Index over the long term; both portfolio investments and counterparties as defined by the Financial Conduct Authority (FCA)) who are returns may differ from those of the Index. The fund may not experience lower deemed both knowledgeable and experienced in matters relating to volatility or provide returns in excess of the Index and may provide lower investments. 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