Data & Research June 16, 2017

Smart Beta Could be the Next Step in TDF Innovation

In a world of heightened fee pressure and low long-term returns, asset managers are redesigning widely used TDFs and some are turning to strategic beta. 
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The defined contribution (DC) space is currently dominated by target-date funds (TDFs). These professionally managed portfolios rebalance participant assets over time by shifting more weight toward bonds and other income-driven investments as opposed to more volatile securities like stocks. But, critics argue that these funds don’t account for individual risk tolerance and they can’t always protect against volatility especially during a market downturn —  a matter that’s especially threatening to those nearing retirement.

In response, fund managers are redesigning these widely-used funds and turning to new strategies including smart beta. According to global research firm Cerulli Associates, 38% of asset managers surveyed believe it is highly likely for smart beta to become a feature of next-generation U.S. target-date products. Fifty percent believe it is somewhat likely.

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Strategic beta or “smart beta” strategies aim for enhanced, risk-adjusted returns by tracking an index based on specific rules or preferences. As opposed to conventional market-cap-weighted passive allocations, these funds weigh securities based on specific factors such as performance, dividends, value, volatility and more. In this sense, smart beta seeks to outperform passive indices by taking an active investing approach.

“In a target-date market dominated by low-cost, passive providers, strategic beta strategies are a way for active managers to compete with pure passive on cost while retaining some of the value-add tenets associated with active management,” explains Dan Cook, analyst at Cerulli. “For the larger target-date providers, strategic beta series can also serve as another option in their target-date product suite, giving plan sponsors the choice between passive, active, and strategic beta.”

Cerulli notes that the increased scrutiny of investment management fees in a low-return DC environment has supported the argument to incorporate smart beta strategies into TDF innovation. Add to that the uncertain interest rate climate and reports indicating overall low returns for the foreseeable future, and smart beta may seem appealing to some fund managers.

Some providers have already rolled out smart beta TDFs. Blackrock recently ran an analysis comparing the performance of several market-cap indices through a hypothetical working lifetime against its smart beta portfolios. It found that in each case, the strategic beta portfolios outperformed their indices.

According to the latest report by Cerulli, “Asset managers incorporating strategic beta into their target-date series could find success by positioning their products as cost-effective strategies capable of reducing volatility and sequencing risk for retirement investors when markets decline.”

Cerulli puts the general cost of smart beta at 25 to 50 basis points depending on the complexity of the strategy.

But while smart beta strategies may help TDF investors mitigate risks and improve their retirement readiness, it likely would complicate the due diligence process at the plan level. This is especially important for DC plan fiduciaries who would have to navigate the ever evolving regulatory space following the implementation of the Department of Labor’s Conflict of Interest Rule. The fiduciary scope will likely tighten as TDFs continue to grow as one of the main drivers behind Americans’ retirement readiness in the DC space. Cerulli finds that as of 2016, TDFs accounted for $1 trillion of 401(k) assets or 52% of all 401(k) contributions. The firm projects that figure will jump to 75% by 2020. Thus, asset managers bringing new TDF products into the DC market will also have to bring all the necessary material to help fiduciaries administrate these products through a well-structured due diligence process.

Cerulli concludes that “Innovation from industry players and increased focus from plan participants could move the retirement readiness needle in the right direction.”

These findings are drawn from the second quarter 2017 issue of “The Cerulli Edge – U.S. Retirement Edition.” Information on obtaining a copy of the report can be found at Cerulli.com.

The Markets June 16, 2017

ESG Used To Motivate Greater Savings and Mitigate Risk

For some segments of the employee population, access to environmentally and socially conscious investment options spurs a significant bump in savings rates.
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Natixis Global Asset Management’s 2017 ESG Report outlines the rising importance placed on environmental, social and governance (ESG) investing.

Aided by the fact that the Department of Labor (DOL) has made ESG investing within retirement plans more palatable from the plan sponsor fiduciary risk perspective, ESG has become a key driver in getting more investors, across generations, to invest more or even start planning for retirement, according to Natixis researchers. 

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The Natixis analysis looks across three investor populations, “including institutional decision makers, financial advisers, individual investors and participants in defined contribution plans in the U.S.,” finding each group is enthusiastic about pursuing ESG opportunities.  

“Individuals clearly tell us that they want their investments to reflect their personal values. The environmental, social and ethical records of the companies included in their investment portfolios matter to investors,” explains David Goodsell, executive director of the Durable Portfolio Construction Research Center at Natixis Global Asset Management.

Goodsell sees “plenty of potential” to incorporate strategies that consider ESG criteria to incent younger investors to increase their participation in company-sponsored retirement plans. Eighty-four percent of Millennials say they would save more for retirement if their plan offered an ESG option, he notes. “We see a real desire from Millennials to ensure that their money does social good.”

Another positive development is the growing maturity and sophistication of ESG products now offered to investors. The marketplace is not just comprised of products that “screen out sin stocks,” for example companies that sell firearms or tobacco. Rather, ESG investments today encompass a wide variety of deeply researched and nuanced strategies that set portfolio weights according to factors such as resource and waste efficiency, exposure to water scarcity or climate change concerns, etc. 

NEXT: ESG Is Not a Political Act 

The Natixis research findings show a large majority of participants feel investing in companies with sound environmental records (70%), companies that are seen as doing social good (71%), and companies making investments that help to fund advancements in healthcare and education (71%) is important. In addition, 78% stress the importance of investing in companies that are “ethically run.”

There is a gap in the sentiment between how men and women perceive ESG and its framework within their portfolios, Goodsell observes. A slightly larger percentage of women (76%) are concerned with ESG factors compared to men (72%). “Investing in ethically run companies is where respondents place the greatest emphasis, with 81% of women saying it is important, 31% of whom say it is very important.”

“Although ESG may not be as familiar to financial advisers as traditional investment strategies, the discipline is gaining more attention within the financial services industry,” Goodsell continues. “Forty percent of advisers globally are already using ESG seeking to mitigate governance and social risks. Additionally, institutions surveyed anticipate a greater role for ESG, with six in 10 predicting that it will become standard practice for their organizations within the next five years.”

Perhaps most important in the context of ERISA retirement plans, which place a strong emphasis on plan fiduciaries considering participant’s economic needs prior to their social or political aspirations, 55% of advisers say there is potentially significant alpha to be found in ESG. At the same time, 57% say ESG can help mitigate headline risks.

The idea is that, as the Natixis research frames it, “the fundamentals of a company are only part of the story. Understanding how the board governs itself, its business, the environment in which it works and its employees live, as well as how it treats people are equally critical to discovering good, long-term investments … There are real world changes, like population growth, urbanization, and resource depletion, that may have an immeasurable effect on equity markets and transform companies as we know them today.”

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