Redesigning for Efficiency

In a recent project with a defined benefit pension fund client, our Outsourced CIO (OCIO) team helped the client by analyzing their equity portfolio and redesigning it for much improved efficiency.

Getting to Efficient

Allocating to global equity markets comes with expectations for both returns and the level of risk. Determining the appropriate level of active risk to target is key.

Many mid- to large-sized defined benefit plans tend to invest with a relatively high number of managers with the belief that this will help meet return objectives and provide good diversification.

The challenge, however, is to allocate without overdiversifying the plan — because this results in reduced active risk, increased fees, and reduced ability to meet return objectives.

Our work with this client provided an alternative approach to portfolio construction, using a mix of active, index, and smart beta/ factor-based investment strategies. Central to this work was the mix of quantitative analysis and qualitative assessment required to make these changes, educate the client, and begin successful implementation.

The result was a more efficient portfolio where the active and smart beta/factor-based strategies drive active risk and the factor- based and security-specific risk was both intended and understood.

First, Get a Clear Picture

Our starting point, as always, was to determine the client’s needs and objectives for the overall plan and, more specifically, the equity allocation.

The client did not require a large amount of active risk for the equity portfolio. Based on return expectations for the overall portfolio as well as a large allocation to alternative assets, an active risk target of around 1% was required for the global equity allocation.

Initial State Analysis

Our client intended to adopt a new benchmark, the MSCI All Country World IMI Index. We evaluated the client’s existing mix of portfolio-level holdings against the new benchmark. Our analysis showed the client's existing holdings had the following characteristics:

  • The investment mix included more than 20 active strategies (across regions, capitalizations and style) as well as low volatility and regional index strategies.
  • Overall active risk was 1.15%.
  • Of that risk, factor risk accounted for 86% while stock-specific risk was only 14%.
  • Crucially, active strategies were not driving the actual active risk. Instead, country/ currency bets within the index strategies were driving 78% of active risk.
  • We also found that there was no dominant style exposure.

These findings were broadly consistent with what we have seen in other plans and with the findings of a recent State Street paper on overdiversification.2 The paper analyzed data for 88 US defined benefit plans and found that there was a direct relationship between plan size and the number of managers held. On average, plans held 17 public equity funds and we found that as a result overdiversification is problematic for many plan sponsors, since it results in declining active risk to such a point where expected return targets are potentially unrealistic.

Aligning to the Benchmark

Next, we adjusted the portfolio’s index positions to eliminate country and currency ‘mis-weights’ relative to the ACWI IMI index, bringing it into line with new benchmark's weightings. This change resulted in the following:

  • Active risk was reduced from 1.15% to 0.64%.
  • 93% of active risk driven by active strategies.
  • Nearly 7% of risk was driven by allocation to low volatility equities.
  • Factor and security specific risk were more balanced at 56% and 44%, respectively.

Clearly, the recent market environment — characterized by low volatility across markets — was playing some role in the current low level of active risk in the portfolio but our analysis highlighted that the composition of the portfolio was not as efficient as it could be if the right allocation mix were used.

Our Solution

Given the challenges of relying on large allocations to active strategies and also that they were already an existing part of the portfolio, we discussed ways the client could increase active risk by allocating to smart beta. This is a transparent framework designed to capture systematic factor returns which have been shown to outperform market- capitalization-weighted (i.e. most common index) benchmarks over time.

Smart beta portfolios combine attributes of both passive and active management.Like passive or index strategies, smart beta portfolios are transparent, they follow an objective set of rules and they're cost efficient. We expect smart beta portfolios to outperform cap-weighted benchmark over time. We assessed the impact of adding smart beta to the portfolio using the State Street All-World Total Market Core Factors Strategy. We kept the allocation to the active portfolio unchanged.

Multifactor strategies provide diversification by combining exposures to various drivers of returns (five factors in the case of Total Market Core Factors Strategy). With low correlations amongst the factors, such strategies can increase the potential for longer- term outperformance while minimizing drawdown effects.

The Total Market Core Factors Strategy uses a bottom-up stock selection process that targets specific factor exposures in its construction. The strategy is optimized to gain and maintain desired exposures to all of the factors with certain security, industry and country constraints.

End State

By changing 20% of the index allocation to the State Street All-World Total Core Factors Strategy (while maintaining the existing allocation to the active portfolio and the low volatility strategy) we achieved the following improvements:

  • Active risk increased from 0.64% to 0.84% (31% increase).
  • Factor risk and security-specific risk became more balanced at 53% and 47%.
  • Risk contribution is more balanced between active, multi-factor and low volatility strategies at 54%, 40%, and 6%, respectively.


Including low volatility and multifactor strategies will, by definition, raise the level of active risk in the portfolio. Indeed, these strategies each bring a higher level of active risk relative to the ACWI IMI index than the active portfolio and the index portfolio which, of course, has no active risk.

The new capital allocation to active, factor-based, and index strategies based on return/ risk objectives allows for a more optimal portfolio that targets risk more precisely and efficiently. The new multifactor allocation increases the active risk by 31% and improves on characteristics such as the factor/security-specific risk split and the risk contribution from the active and factor-based portfolio buckets.

Go Beyond the Numbers

Beyond the numbers, however, there are several qualitative considerations that were required before we finalized our recommendations to the client. These issues are often as important as the data when it comes to implementing this portfolio approach. They can help ensure that the client understands the approach and objectives of the newly constructed portfolio.

Education While the concept of factor premia has been well documented in the academic literature for over 50 years, directly capturing this premia through smart beta investment strategies is a newer construct. For investors to whom smart beta is less familiar, there is generally an extended learning curve. Investors considering an allocation to smart beta should work with a trusted partner — such as an asset manager, index provider or consultant — to become comfortable with the theory behind smart beta investing, the range of factors and why they can earn a premia over time, as well as the ways through which smart beta factors can be implemented in portfolios.

Benchmarking Once an investment decision has been made, the board or investment committee should be similarly educated to understand how to understand and evaluate the performance of smart beta strategies. Smart beta portfolios are relatively new to many investors and can blur the line between active and passive investing. For these reasons many investors are still considering how best to benchmark these portfolios and measure success. While no standard practice has been adopted across the industry, there are different ways to approach the problem. For diversified, multifactor smart beta portfolios, we believe that traditional cap-weighted indices are sensible benchmarks to measure performance.

Role of multifactor State Street believes there are five factors which are the most persistent in driving excess returns across equities: value, size, low volatility, quality and momentum. Each of these factors has wide support in academic literature, has strong underlying economic rationale, and has been shown to be robust and persistent over time. While research demonstrates that factors outperform cap-weighted benchmarks over time, it also shows that individual factor outperformance can be cyclical. For that reason, our Total Market Core Factors Strategy seeks to diversify its exposure across each of the five factors to target the most consistent outperformance over time. A strategy which uses these five factors can take full advantage of both the alpha opportunity and offsetting correlations between these factors.

Role of low volatility As a core part of our investment philosophy for our defined benefit OCIO clients, we believe a dedicated allocation to low volatility equities is prudent. While exposure to this single factor is gained in the multifactor portfolio and there can be greater divergence between performance between the benchmark and investment, the drawdown protection of low volatility equities is beneficial to pension plans because they need to make ongoing benefit payments and they're also highly sensitive to swings in market values for funded status calculations.

Design for Low Turnover

Our final recommendation was to gradually build the multifactor allocation over a period of at least 12 months, with a side-by-side allocation to both low volatility and multifactor strategies.

Our new portfolio construct has three distinct sleeves – active, index, and factor-based (low volatility and multifactor).



Reaching Full Efficiency

Over time, as the allocation to multifactor expands, we will assess the appropriate weights of the multifactor and low volatility allocations. And of course, a deeper look at the composition of the active portfolio would also be warranted to ensure that the risk from that portfolio is being driven by the appropriate regional and sector exposures, as well as stock-specific drivers.

There are many investors that allocated only to a blend of active and index-based strategies and have not seen results in-line with their expectations. We believe that investors should be seeking additional, cost-effective approaches, such as the multifactor smart beta solution we outline here, to help complement and improve on their index and active strategy allocations.

In this case an allocation to an optimized multifactor strategy complemented the client’s existing active and index-based strategies to help them achieve a more optimal and efficient portfolio and one where the risks are both understood and intended.

Our work with the client helped them achieve a more efficient portfolio with increased active risk and improved distribution of factor-based and security-specific risk.

1Smart beta is a set of investment strategies that uses index construction rules to target specific investment factors - such as value, size, volatility, quality or momentum – in a rules-based and transparent way. Factors are held to be key underlying drivers of the risks and return of an asset class.

2"What Free Lunch? The Costs of Overdiversification", Shawn McKay, CFA , Robert Shapiro, CFA, and Ric Thomas, CFA Financial Analysts Journal Q1 2018

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Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.

A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing.   

While diversification does not ensure a profit or guarantee against loss, investors in Smart Beta may diversify across a mix of factors to address cyclical changes in factor performance. However, factors may have high or increasing correlation to each other.   

Investments in mid-sized companies may involve greater risks than in those of larger, better known companies, but may be less volatile than investments in smaller companies. Investments in small-sized companies may involve greater risks than in those of larger, better known companies.   

Value stocks can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.   

Volatility management techniques may result in periods of loss and underperformance, may limit the ability to participate in rising markets and may increase transaction costs.   
Growth stocks may underperform stocks in other broad style categories (and the stock market as a whole) over any period of time and may shift in and out of favor with investors generally, sometimes rapidly.   

A momentum style of investing that emphasizes investing in securities that have had higher recent price performance compared to other securities, which is subject to the risk that these securities may be more volatile and can turn quickly and cause significant variation from other types of investments.   

A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.   

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