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Choosing The Right Index
By Paul Amery | 26 April, 2012

Imke Hollander, equity strategist at Blue Sky Group, manager of the KLM pension funds, tells Paul Amery, editor of about her firm’s increasing use of alternative beta strategies. Imke will be talking about “Choosing the Right Index” at our forthcoming conference in Amsterdam, Inside ETFs Europe, on May 15-16 Please describe how Blue Sky operates

Hollander: We are the fiduciary manager for the three KLM pension funds. These represent over 90% of our overall assets under management. We also represent some other corporate and industry-wide pension funds. What’s the overall asset allocation for the KLM pension funds?

Hollander: Strategically, our clients have around 30-40% in equities, 10-15% in real estate and typically 45-55% in fixed income. Within equities, what percentage is held in index-following mandates?

Hollander: We index about 60% of the portfolio.  For some of the funds there is a small allocation of around 5-10% of the equity segment in environmental, social and governance (ESG) strategies. Defensive equity strategies make up 5% of the portfolio of most of our customers, and that’s soon to rise to 10%.  The rest is in traditional strategies, based on capitalisation-weighted indices, where we follow the MSCI IMI benchmarks in different geographical regions. What has prompted your move into defensive equity strategies?

Hollander: We’ve always been interested in quantitative equity approaches, which of course include so-called alternative beta strategies. The market turmoil at the turn of the century and again in 2007-08 also stimulated our interest in this area.

It’s probably also worth pointing out that some of our pension fund clients are quite conservative by nature. Our pilots’ pension scheme, for example, has used an option overlay strategy since 2002: we buy average price put options, with a fifth of them expiring each year.

Our defensive equity index strategies are based on the prospect of lowering portfolio volatility but maintaining the level of prospective returns.  The advantage is that these strategies can reduce the volatility of the equity portfolio, which in turn translates directly into a less volatile solvency ratio. This principle has great appeal to us since alternative ways of reducing risk—increasing the portfolio weighting in fixed income, for example—would be more expensive from a funding perspective. What kind of defensive equity strategies do you use?

Hollander: We have a mixture of low-volatility and maximum diversification strategies. We’ve looked at other non-market cap weighted strategies as well, but decided they were of less interest for this particular portfolio, because they offered a less favourable maximum drawdown or a smaller reduction in volatility. We want defensive equity and some of the other strategies were not defensive enough. Have you looked at other alternatives to capitalisation weighting?

Hollander: Yes, we’ve reviewed almost all of them. In general, we’ve concluded that market cap-weighting is not a very efficient way of doing things and that almost all of the other strategies should work better over the longer term. Of course, you need to avoid moving into stocks that are too illiquid, or into portfolios that have too high a turnover rate. The absolute minimum variance portfolio, for example, turns out to be very unstable, with high turnover and transaction costs.

These concerns can easily be addressed by looking for more stable and liquid portfolios where you allow for a little bit more risk. Assuming you are able to stay on the efficient frontier this will actually add a relatively large amount to the return. Having said that, in general we prefer the “active” versions of the alternative beta strategies as index providers tend to solve the illiquidity and turnover problem themselves by adding constraints that are usually linked to the market cap-weighted index. The MSCI low volatility index, for example, will generally exhibit characteristics that are much more in line than active low-volatility strategies with the original market cap-weighted index.

Apart from maximum diversification and low-vol, we’ve also been attracted by the risk-weighted index strategies, such as equal risk contribution.  However, these tend to be more volatile and require further research. Perhaps we will reconsider these in due course. Do you manage these strategies internally or are they managed by other firms on your behalf?

Hollander: We have external managers doing this for us. So do you then measure their performance against some of the newer index benchmarks that replicate alternative beta strategies?

Hollander: No, when we have non-cap-weighted strategies we prefer not to use a benchmark as the resulting tracking error would use unintentionally consume some of our risk budget, which we prefer not to do. But we need to assess managers in some way, and so we use Sharpe ratios, as well as at the performance of both cap-weighted and low-vol indices. There’s an increasing number of ETFs following some of these index strategies. Do you use them?

Hollander: No—we’re big enough to be able to identify the strategy we want and to hire a manager to follow it. For smaller funds ETFs are one of the possible solutions. But ETFs tend to be quite expensive and we also have doubts about some of the underlying benchmarks. How widespread is the usage of alternative beta strategies in your peer grouplet’s say among pension funds in Benelux and Northern Europe?

Hollander: We’re probably ahead of the game in actually implementing these types of portfolio approaches. But this theme is gaining popularity rapidly. So you don’t think this is a fad?

Hollander: No, I don’t think so.  One of the reasons for saying this is that some of these strategies are not that new: low-vol as an investment approach has been around for over 40 years. One of the low-vol managers told us recently they have been running funds along these lines since the 1980s. So the concept is not new, but the recent interest levels are a lot higher.

Of course, if the markets have a good recovery phase then some people will switch back to cap-weighting.  But part of the interest will probably remain.

It’s important also to remember that there’s no holy grail.  Each approach has its drawbacks and will perform better or worse at different points in the cycle.

And if you want to compare yourself against the broadest investment universe then you still need capitalisation-weighted benchmarks. Some investors, of course, can’t stray too far from that cap-weighted starting point because of regulatory constraints.

Alternative beta will continue to grow, in my opinion, but it’s not going to replace the traditional benchmarks.

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