Index funds – Feature
Index investing is changing in a bid to manage risk better. Andrew Holt looks at what investors need to know about the new hybrid funds hitting the market.
A new breed of index fund has appeared on the investment block. These “third way” index funds offer a combination of active and passive styles. And, for the right institutional inves- tor, they provide a huge benefit. But what exactly are they? “They rely on a systematic rules- based style of investing, long used by quant managers,” says Amin Rajan, chief executive of Create Research, a boutique spe- cialising in strategic change in investment management. “How- ever, their substantive adoption in the pension world only gained traction after the 2008 crisis, when conventional asset- based diversification came unhinged when it was needed most.” This, says Rajan, brought into focus the Yale model, which favours alternatives. Yet it did just as badly as the long-only model, favouring mainstream assets.
“It was a cathartic
moment when pension plans started looking at investing through the lens of factor investing,” he adds. This approach rests, essentially, on strong evidence that seem- ingly different asset classes can have unusually high correla- tions, due to their common exposure to underlying risk fac- tors. “These are the smallest systematic units that influence investment return and its associated risk,” Rajan says. “Factor investing is seen as a third way of investing that combines the best of actives and passives while compensating for their respective weaknesses.”
Factor calls
The active component relies on portfolio managers to make calls on which factors to choose, what data to deploy and when to dial up, dial down or switch off a factor. The passive compo- nent, in turn, relies on the low costs associated with a rules- based systematic strategy that is a lot cheaper than traditional stock picking. Deborah Fuhr, managing partner at research and consultancy firm ETFGi, says there is some crossover between factor invest- ing and smart beta. “For factor and smart beta in general, it is fac- tors where academic research that shows if you invest in them for long-time periods you will do better than the market cap. “In terms of smart beta investing, it is able to tilt quickly to a factor you think is going to perform well, at any time and in any size you want while not having to adjust your core hold- ings,” she adds.
Value drivers
These new index funds have the benefit over their traditional counterparts in that they do not have to invest in overvalued stocks, unless they want to. “By tracking traditional market indi- ces, such as the FTSE100 or S&P500, passive funds are over- weight large expensive companies at the expense of lower-priced small companies,” Rajan says. “Large ones attract new money owing to their sheer size rather than their intrinsic worth.
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