The low-yield and low-volatility environment along with rising entitlement payouts have forced pension funds in the Asia-Pacific region to diversify and look beyond traditional strategies, with more than 60% of buy side firms forecasting a rise in demand for index-linked structured products in the next 12 months, according to a recent SRP survey. SRP spoke to Priscilla Luk, director of index research and design at S&P Dow Jones Indices, about the latest developments in the alternative beta space and how institutional investors can benefit from “smarter” allocation into this relatively new space.
What is the driving force behind the popularity of alternative beta products in Asia?
The major driving force behind alternative beta in Asia comes from the increasing awareness on the part of institutional investors of the high costs associated with actively managed products, accelerated by the search for yield and lower risk tolerance. They are now turning their attention towards more cost-efficient instruments such as exchange-traded products (ETPs).
The cost consideration has planted the seeds for the emergence of alternative beta – which are portfolios and indices constructed with objectives to capture specific systematic risk factors, as opposed to market cap-weighted indices that track general market movement. They are smarter than traditional active management in that the selected portfolios capture a portion of different risk premiums constituting part of the “alpha” or the excess return that actively managed products seek to generate, but only at a fraction of their costs.
Therefore, it allows asset managers to get exposure to the risk factors required to beat the market benchmark while keeping costs to a minimum. They can pick up a variety of thematic selection criteria such as low volatility, momentum, value, quality and so on subject to their own needs and objectives.
Another benefit of utilising alternative beta is the availability of well-researched literature and back testing which tells investors how each alternative beta category would have performed in historical situations using real-time data. Variations of smart indices such as S&P low volatility indices, when back tested against the S&P500 index, had historically outperformed the broad market-cap based benchmark over the past 15 years on a risk-adjusted basis.
Are Asian investors (who are typically more short term oriented and yield driven) ready to embrace smart beta products and use them in their investment portfolios?
We do recognise the very different investing culture and risk orientation of Asian investors. However, many of our Asian clients are no strangers to the use of alternative index strategies, even though they might not be aware. Pension funds and other asset owner institutions are at the forefront of embracing alternative beta strategies. For instance, Japan’s Government Pension Investment Fund (GPIF) has recently readjusted its mandate and considered allocating more assets into alternative betas.
When large buy side firms in the region started making those reallocation moves, it sent a signal to the rest of the market, prompting more investors to follow. Building on the trend-following nature of Asian investors, we expect this trend will pick up momentum. From what we heard from our clients the prevailing investment need is to enhance portfolio return amid low interest rates. In doing so many of them combine active management strategies with alternative beta which has historically shown good performance.
Do you think alternative beta products will perform in the current low interest rate environment and economic outlook, compared with traditional market indices?
We do not really see interest rates as a major determinant when it comes to deciding what indexing strategies to pursue. In fact, the prevailing low interest rate is a product of loose monetary policy by the central banks around the world in response to the financial crisis and hence correlated highly with other economic variables such as GDP, and hence cannot be easily singled out.
Having said that, the anticipated interest rate hikes as in the US right now usually signal the economy is doing well and corporate earnings are robust – which in turn fuel the growth of equity markets. While it is difficult to generalise the prospects on equities across region due to economic differences, alternative beta products have indeed historically outperformed equities on a risk-adjusted basis.
For example, according to our back testing results from the period of 1999 to August 2014, our smart beta variations such as S&P500 Pure Value, S&P600 Small Cap, and S&P500 Quality had achieved an average annualised return ranging from 9% to 11.5% compared with the 4% of S&P 500, while S&P Low Volatility had a much higher return to risk ratio than that of the market.
The fact that alternative beta products typically have higher return to risk ratios means that these strategies enable better utilisation of risk over the long term, and have proved resilient to financial market shocks and economic downturn in the past 15 years. The smarter portfolio construction using a non-market cap basis makes it possible to preserve capital when the market goes down and give meaningful exposure during a market uptrend.