The Next Evolution in Indexing: DC Plans and Smart Beta

Smart beta seeks additional outperformance and is a flexible enhancement to traditional index. Here’s what you should consider as a defined contribution plan sponsor.
By PS

You have to have a long memory or be a keen student of market history to remember that index strategies were once considered a radical idea. When the concept of indexing was first introduced in 1971, not only was index construction complicated, but the idea that investors would ‘settle’ for market returns instead of trying to pick a portfolio of winners seemed unlikely to catch on.

As it turned out, settling for market returns might have been a good idea during much of the 401(k) era, the nearly four decades since the 401(k) entered the tax code in 1978. Despite some notable bear markets, average equity returns were strong, and steadily declining interest rates drove historic bond market returns. As index funds became increasingly efficient and active alpha became harder to find, index strategies became an easy choice for plan sponsors to consider for defined contribution (DC) plans.

But, is index still the right choice? In a sense, the obvious answer is yes. Index remains an important tool for building investment menus. But markets, information and demographics have changed. Today, we are confronted with an aging population that’s also living longer. At the same time, long-term yields remain low and industry projections forecast an extended period of weaker market returns. Simply put, the challenges of retirement investing are changing.

NEXT: The next evolution of DC plans may be here

Fortunately, investment management has continued to evolve as the markets have grown more complicated. Today’s data technology gives asset managers greater transparency and insight into market drivers—commonly referred to as factors. What’s more, asset managers now have a greater ability to isolate factors and create efficient exposures designed to meet specific objectives. 

One form of factor investing may be of particular interest to DC plan sponsors: smart beta. Smart beta may be described as a method for potentially generating outperformance at a lower cost than traditional active management—and that is certainly an appealing consideration for many plan sponsors. At the same time, smart beta is index-based, long-only, and process-driven. Depending on their construction methodology, smart beta indexes may look very much like the cap-weighted indexes they are derived from in terms of sector diversification.

The difference is that cap-weighted indexes are designed to capture the market, while smart beta strategies are designed to capture specific currents within the market. Smart beta strategies can be used as an index replacement but tilted in ways that may reinforce the plan’s objective. Diversified multifactor strategies, for example, seek outperformance at the same risk level as the overall market by tilting toward momentum, size effect, value and quality factors. Minimum volatility strategies, on the other hand, seek to match market returns with less risk—which may be of interest to older participants and retirees who still seek growth but are sensitive to market volatility.

The flexibility of smart beta strategies can be seen through their potential use within a target-date fund. For example, they can be incorporated into the early portion of the fund’s glidepath with the goal of reinforcing growth for younger participants. Later in its glidepath, as participants approach retirement age, other smart beta strategies can be substituted for the cap weighted index to potentially reduce volatility. This, we believe, demonstrates the flexibility of smart beta strategies: They are not only a potential source of outperformance, but are also an enhanced approach to traditional indexing.

NEXT: How to adopt smart beta in DC plans

I believe that smart beta will follow a similar trajectory to indexing—it will go from being a seemingly radical idea to becoming a mainstay of retirement portfolios. The ground work for this evolution has already been laid: BlackRock’s 2017 DC Pulse Survey found that for 51% of plan sponsors, smart beta is on their radar. More interestingly, of these plan sponsors:

  • 75% agree that smart beta strategies could serve as a potential replacement for a cap-weighted index;
  • 86% see smart beta as an alternative to traditional active management; and
  • 81% believe it’s appropriate to offer smart beta as part of a multi-asset class solution, such as a target-date fund.

The factor insights behind smart beta are not new. What is new however, is the ability to efficiently implement factors through smart beta strategies. I’m optimistic that as more plan sponsors examine smart beta and how various smart beta strategies are implemented, the more the retirement industry will come to see that smart beta can play an important role in delivering better retirement outcomes for clients.

By Anne Ackerley, head of BlackRock's US & Canada Defined Contribution Group

 

This material is provided for educational purposes only. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2017 and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Reliance upon information in this material is at the sole discretion of the reader.

Asset allocation and diversification strategies do not guarantee profit and may not protect against loss. Past performance is no guarantee of future results.

Any opinions of the author do not necessarily reflect the stance of Asset International or its affiliates.

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