Factor indexes may put hurt on active managers
By Drew Carter | February 22, 2010
New factor-based strategies might give index managers a way to replicate active returns, turning up the heat on traditional active managers.
In recent years, investment banks and other firms have developed hedge-fund replication strategies that rely on factor exposures. Now, use of these factors is being extended to traditional money management.
Index providers are trying to make the task easier. MSCI Barra has a fleet of factor indexes that aim to deliver market returns plus exposure to one of five factors: momentum; volatility; leverage; value; and earnings yield. The company has licensed the indexes to BlackRock (BLK) Inc. (BLK)'s iShares in the U.S. and to Deutsche Bank's db x-trackers in the U.K.
Meanwhile, Russell Investments teamed up with risk and portfolio optimization specialist Axioma Inc. to produce a series of momentum-based indexes in December. Other indexes might be created based on other factors used in Axioma's models, including value, leverage, size and liquidity. In November, Standard & Poor's Financial Services LLC introduced an index that dynamically allocates between the S&P 500 index and a volatility hedge. And FTSE International Ltd. plans to launch a factor index in March.
State Street Global Advisors, in addition to tracking indexes, also has developed custom systematic strategies for capturing individual factors for institutional clients, said Richard J. Hannam, London-based managing director and European head of passive equity. The firm is running $6 billion in such strategies, which include those replicating the Research Affiliates Fundamental Index benchmarks.
And investment banks are getting in on factor replication, too. Deutsche Bank AG and Morgan Stanley (MS) have developed factor-based systematic strategies by creating indexes, then offering swap- and derivatives-based investments off the indexes.
“As clients see the benefit from quantitative strategies that dynamically adjust to market conditions, creating these new investment opportunities continues to be an area of focus for us,” Jo Ninian, London-based vice president at Morgan Stanley, said in an e-mail response to questions. She said the bank would consider selling licensing rights on its indexes, too.
Beta in alpha's clothes
Proponents of these new strategies say active managers overcharge for outperformance because much of it can be replicated cheaply — that is, some managers are parading beta as alpha.
“There's an absolute production line of these (strategies) coming out because they've seen an appetite from pension funds and sovereign wealth funds to capture these factors in a systematic way,” said John Belgrove, principal in London at Hewitt Associates.
Consultants estimate fees on the strategies as being half or less of traditional active management fees.
Towers Watson & Co. promotes the idea of not overpaying for beta. While the ideas behind factor-based products aren't new, implementing them is “quite radical,” said Phil Tindall, a London-based senior consultant at Towers Watson.
“For a client with the right mindset and governance, definitely ... this way of thinking is the way forward,” he said. “How you do it is the $64,000 question.”
Factor indexes also could be used to improve benchmarks for existing active managers, something Mr. Belgrove said would be “very appropriate.” As benchmarks, they can “potentially raise the bar (for active managers), particularly if one feels there's an advantage to a particular (factor).” He added, however, that for its clients, Hewitt recommends an unconstrained approach: “Our belief has been to move away from benchmarks.”
Experts say that a report in December commissioned by the 2.59 trillion Norwegian kroner ($458 billion) Government Pension Fund-Global, Oslo, will raise awareness of systematic factor-based strategies and the issue of overpaying for alpha. That report called for the fund to impose factor tilts onto customized benchmark portfolios to improve returns and to raise the bar for active managers (Pensions & Investments, Jan. 25).
Experts differ as to whether these are passive or active strategies.
Rumi Masih, managing director and head of the strategic investment advisory group at JPMorgan Asset Management in New York, said these new strategies are in the middle of the risk/return spectrum. “It's certainly not 'set-it-and-forget-it' indexing, but it's not active either.”
However, Divyesh Hindocha, global director of consulting at Mercer LLC in London, said factor-based systematic strategies by themselves can't provide consistent outperformance without some inclusion of active management.
“Although they may be systematic ... you need to change the exposure to the factors over time,” so, these strategies just recast active management to a matter of superior factor selection from superior security selection, he said. “Whenever you're making a conscious decision ... you're effectively making an active management decision.”
William E. Jacques, partner, executive vice president and chief investment officer at quant equity manager Martingale Asset Management LP, Boston, agreed the strategies will need some element of active management. “You can't just leave a rule in place and expect it to produce money,” he said.
He added that the new strategies could be a boon to firms like his. “This may help the rebirth of the quant manager, who's been under fire on many different fronts, because clearly it's going to take someone who's an index-oriented manager to manage assets against this new wave of benchmarks.”
However, active managers say they aren't going anywhere. They've heard similar threats before. “You can't get away from the fact that human judgment is needed for sustainable, repeatable results,” said Helena Morrissey, CEO of Newton Asset Management, London, which managed £42.1 billion ($66.7 billion) as of Dec. 31.
John McLaughlin, head of multiasset and structured solutions at Schroder Investment Management, London, said people at his firm are “not blasť or complacent (but) we're not that worried” about new systematic factor strategies. He said quantitative screening is part of a robust active investment strategy, but isn't a complete one. “For us, the intervention of the human being is irreplaceable,” he said.
However, some index providers think cheaply available factor-based exposures could help traditional managers adjust their exposure to various risk factors. Remy Briand, Geneva-based managing director and global head of index and applied research at MSCI Barra, said managers could use factor-based ETFs instead of buying or selling securities.
Factor ETFs would be “a much more simple and cost-effective way of doing” the same thing, Mr. Briand said. “It's as much an asset manager product as asset owner (one).”