In an effort to reduce risk, Canada’s institutional investors are beginning to adopt smart beta indexes as an alternative to the traditional uses of market cap-weighted indexes. Smart beta indexes blur the lines between active and passive investing by focusing on specific factors beyond the broad passive market exposure offered by traditional market cap-weighted indexes. While still “rules-based” like traditional market indexes, these indexes differ by helping investors replicate certain factors, market segments or investment strategies, making them useful for a wider variety of investment objectives.
For example, a fundamentally weighted index, based on fundamental metrics such as earnings, can access stocks weighted on economic factors versus price. A defensive index can seek defensive-oriented, or non-cyclical, stocks. And a factor index can isolate an investment factor such as stock momentum, growth or quality by selecting and weighting stocks based on their exposure to these factors.
Read: Interest in smart beta higher in Canada
Russell Investments’ 2014 Global Smart Beta Survey gauged the perception and adoption of smart beta indexes among 181 institutional investors with $1 billion or more in assets across North America and Europe. Of the Canadian respondents, 95% believe investment strategy is an appropriate application for smart beta indexes, compared with less than 70% of non-Canadian respondents.
Also, Canadian pension plans use smart beta strategies mainly for de-risking. The majority (86%) of respondents cited risk reduction as an objective leading to evaluation of smart beta strategies, while only 43% cited return enhancement. All Canadian respondents currently using smart beta indexes use low-volatility strategies, compared with 48%, on average, of non-Canadian respondents. Smart beta indexes can be useful in de-risking.
Read: Appetite for smart beta growing among institutional investors
For example, a Canadian pension fund may want to keep its current equity allocation but worry about downside risk at this stage in the global market cycle. Investing a portion of the portfolio in an index-based strategy that seeks defensiveoriented stocks may make sense.
Put it to use
Awareness and adoption levels of smart beta index-based investment strategies change from larger Canadian pension plans to smaller plans
The large pension market in Canada is dominated by a handful of super pension funds, typically with $50 billion or more in assets, each with in-house research and investment capabilities. These funds have spent time researching smart beta strategies and have a handle on how they might be implemented. Yet since these strategies are new and relatively untested, they may still seek outside expertise.
Small and mid-size pension plans in Canada are much less aware and engaged with smart beta, but they can also benefit from it. It’s partly an education issue. For example, many of these plans use active managers for all aspects of the portfolio, when a blend of active and smart beta index-based approaches may make more sense. If the pension plan is simply looking for a targeted exposure to defensive- or low-volatility-oriented stocks—or if it wants to increase exposure to a certain investment factor—a smart beta index may be a more efficient way to accomplish this as part of an active strategy.
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Since smart beta education and advice aren’t yet widely available or standardized, Canadian pension plans interested in smart beta face challenges. However, smart beta indexes can be a useful de-risking tool for active managers. That’s why investors should evaluate them as thoroughly as they would active strategies.
Joseph Gelly is managing director and head of institutional with Russell Investments Canada Ltd.
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