Smart indexing
A smarter way to avoid these potential pitfalls is to design your own index, instead of simply buying exposure to each of the five factors, according to Van Mulligen.
“Investors used to just have the choice between active and passive investments, but index providers are increasingly moving towards active management.
“As an institutional investor, I can now ask an index provider to design a proprietary index based on the risk/return profile I want, and implement this strategy in a passive way,” he says.
A big advantage is that such a setting allows the end investors to take ownership of the investment process, instead of outsourcing everything to an active manager.
“The investment decisions can be repatriated to a pension fund’s investment committee, which can decide on the factor mix and even introduce specific ESG criteria,” he says. “In traditional asset management that has always been more difficult.”
For one of Achmea IM’s clients, a company pension fund with assets of €3bn, Achmea IM went down this route last October.
“Together with two index providers, ERI Scientific Beta and FTSE, we have developed bespoke indices for this client, using the same factors we give our active factor managers, and with an ESG-screen in the form of a CO2-filter on top,” he says.
Van Mulligen emphasises that a bespoke index is “quite a bit more expensive than a simple tracker. You will be surprised about the fees some index providers charge you, though it is of course still cheaper than traditional active management”.
As an institutional investor, Van Mulligen’s definition of ‘expensive’ is a little demanding, it turns out. “The fee depends on your ticket, but it’s less than 0.15%. That may look cheap, but I pay far less than 1% for active management as well.”
For the smart beta approach, Van Mulligen deliberately opted for two different index providers, a strategy that he also adopts for active managers.
“Ideally, we look for two strategies that complement each other,” he explains. “The FTSE multi-factor index has a concentrated portfolio, in which only stocks with ‘good’ factor qualities are bought. ERI has a much broader portfolio, though the tracking errors of both versus the MSCI World are about the same: 2-3% ex-ante.”
The active advantage
Although both indices also take risks on a stock level into account, flexibility remains limited because of their nature. That’s why Van Mulligen continues to see a place for active factor managers.
“I don’t think we will ever completely switch to smart beta, because you need their flexibility,” he says, giving the example of a value index versus a value manager.
“A value index selects stocks based on price to book and price to cashflow, and doesn’t really ever change this method.
“The smart beta providers may make minor adjustments to their index in consultation with clients, but that only happens once a year.”
