European funds souring over smart beta options

European defined contribution plan sponsors are beginning to reconsider the value of smart beta investments in their portfolios because of disappointing performance.

Smart beta — an umbrella label for factor-driven equity strategies that combine elements of passive and active investing — had a strong run in terms of inflows. Assets invested in broad smart beta strategies more than doubled to $990 billion at year-end 2017 from the start of 2014, according to data from Morningstar Inc., Chicago.

However, moving into 2019, investors — due to increasing volatility in equity markets — are questioning if they have sufficient equity allocation and the wisdom of holding smart beta strategies.

"What we're seeing across the board is plans rethinking their approach and adopting innovative ways to be able to generate returns in the coming low-returns and high-volatility era," said Christian Lemaire, global head of retirement solutions at Amundi in Paris.

"We are also seeing many pension funds invest in passive products, such as index funds, to benefit from lower fees. If you look at asset allocation in particular, smart beta is the least embraced," he said.

The €300 million ($341 million) United Pensions, Brussels — a multiemployer, cross-border fund — already has reduced its exposure to smart beta equity to zero from 35%.

The United Pensions plan, which is sponsored by Aon PLC, runs the retirement assets of corporations such as Dow Chemical Co., which moved its European retirement plans' assets into United Pensions' cross-border arrangement in 2018.

Hans Rekker, client executive, retirement solutions at Aon Netherlands in Amsterdam, cited under-performance from smart beta strategies as a reason for United Pensions to replace them with simple passive strategies in its €43.5 million equity portfolio.

"We introduced smart beta around three to four years ago ... (but) the return was not as expected. It was worse than simple passive," Mr. Rekker said.

Adam Laird, head of ETF strategy, Northern Europe at Lyxor Asset Management in London, said there is "not so much of a pullback but a re-examining of smart beta that is going on."

"The reason behind it is that many of the smart beta strategies were targeting value companies," Mr. Laird said. "But in the last years value has underperformed. Most investors were targeting one factor, and this is very much what was sold," he added.

But now investors in France, Switzerland and the U.K. are trying to get out of single-factor exposure, sources said.

Some managers think defined contribution plans still will opt for smart beta approaches that can offer downside protection and act as a diversifier — such as low-volatility or high-dividend strategies — rather than try to get outperformance from the strategies.

"Investors are reorienting away from the factor framework; instead of targeting classic factors they focus on the level of risk, income and return," Mr. Laird said.

Ana Harris, global head of equity portfolio strategists at State Street Global Advisors in London, said: "Over this year we have seen a dispersion in individual factor performance individually. Momentum has done well but value has struggled. It's been challenging for those (investors) who had exposure to one factor."

"And (now) investors are a little bit concerned about a single-factor exposure and if they have an exposure that is appropriately diversified," she added.

"Diversified multifactors could smooth the effects of cyclicality of single-factor performance," Ms. Harris noted, adding a multifactor approach can add 50 basis points to 150 basis points to the performance over a market cycle.

"Investors need to be cautious not to miss out ... they could lose potentials returns from value stocks if they reduce smart beta exposure based on recent underperformance," she said.

Vitali Kalesnik, partner, director of research for Europe at Research Affiliates LLC in London, said that trend-chasing can cost investors on average 200 basis points a year.

But some sources said they think diversification benefits of smart beta are limited and factors might go down together. Nicolas Just, deputy CEO and chief investment officer at Seeyond, an active quantitative subsidiary of Natixis Investment Managers in Paris, sees one other challenge with a multifactor approach to smart beta investing.

"We don't see massive inflows into multifactor strategies ... (factors) can have different outcomes when it comes to volatility." Instead, Seeyond sees demand for low-volatility strategies, he said, adding, "In the last 10 months we seen inflows of around €1.2 billion" into those strategies.