PLANSPONSOR - December 2017/January 2018 - 35

says. " We want to have a manager's top
20 high-conviction ideas, rather than the
50th best idea. That results in an increase
in a manager's 'active share,' and research
shows a reliable link between greater
active share and long-term success in
equity investing. "
Not all choices of passive management
are made out of resignation. " Our
view is that sponsors should go to passive
when they don't have confidence in active
managers, " says Smith. " Instead, look at
more esoteric and complex strategies-
hedge funds or private debt, or other areas
that take more of the committee's time. "
Some plans may not have the
resources to oversee active management,
Bargeron says. " Finding and monitoring
skilled active managers takes a lot of
time and effort, and creating a portfolio
of them requires even more. On top of
that, we encourage contrarian use of
portfolio management, which means
adding capital to those managers that are
underperforming. All this is easier said
than done, when a plan doesn't have the
required level of governance. "
There is a middle ground between
a passive approach that is satisfied with
market returns and one that will pay
for a high-maintenance stable of active
managers: smart beta-also known as
factor investing.
Smart beta strategies are rules-based,
and structure their portfolios on the
basis of quantitatively divined factors that
influence security returns. Over decades,
investors and researchers have identified
hundreds of factors promising abovemarket
returns, but most of them disappear
as the market comes to recognize
them. A few seem to be timeless, however:
valuation below the market average;
smaller company size; high financial
quality; low volatility; and momentum-
i.e., the tendency of a stock to keep moving
in one direction or another.
Many investment managers are
creating and marketing a wide range
of smart beta strategies, and investors
find them appealing. As smart beta
Return and Risk of Common Factors, 1970 - September 30, 2017
n Return
20%
15%
10%
5%
0%
Source: Northern Trust Asset Management
Russell 1000
Value
Momentum Low volatility Quality
l Sharpe ratio
1.0
0.5
management requires less human input,
fees are typically lower than are those for
fully active management, although not as
low as for straight index funds.
Northern Trust Asset Management
offers a factor-based approach it calls engineered
equity and has built up managed
assets to nearly $20 billion. Matt Peron,
managing director of global equity, in the
Chicago office, points out the historical
excess returns of the popular factors: All
have offered significant advantages to
the broad market over the long term (see
chart). " The factors can be potent, but
have extended periods of drawdowns such
as the one we see now in value versus
growth, " he explains.
For that reason, many investment
firms construct diversified portfolios of
smart beta strategies, to dampen the cycles
and mitigate drawdowns. Each firm builds
its factors in its own way, so the results
among strategies could vary widely.
" Selecting smart beta managers is
similar to active management, " Bargeron
says. " Performance runs in cycles, and
the cycles can run for decades. That's why
moving to smart beta is an active decision,
and it's not just cheap active management
that is guaranteed to outperform. "
Smith reminds sponsors that active
management plays multiple roles in a DB
portfolio. " Are the active managers there
only to outperform the benchmark, or
can they also provide downside protection
when markets are challenged? " he will ask.
He notes that many sponsors have
been patient and stayed with active
managers despite underperformance, as
they are more concerned about downside
risk-and preserving the enormous
gains of the past nine years-than they
are about missing some of the upside in a
frothy market. -John Keefe
KEY POINTS
* Many plan sponsors have shifted
assets from active management
into passive strategies because
of high manager fees, underperformance,
and the sponsor's
inability to monitor the manager
efficiently.
* A middle ground between a
passive approach satisfied with
market returns and one willing
to pay for a high-maintenance
stable of active managers is
smart beta.
* Many investment firms construct
diversified portfolios of smart
beta strategies, to dampen
performance cycles and
mitigate drawdowns.
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