In recent years, DC plans have often found it difficult to focus on investment as they have grappled with a series of legislative and regulatory changes.
Among the challenges they have faced: automatic enrolment, the charge cap, implications of ‘pension freedoms’ and value for money considerations, and, more recently, transactions cost disclosures. Investment—one of the most important drivers of members’ retirement outcomes—was likely not at the top of the agenda.
Recently, though, DC plans have started to refocus on investing. As they examine their approaches and strategies, DC plans and their advisors are looking at their default strategies, in particular the growth phase of those strategies. They are making changes to what have typically been fairly simplistic approaches, usually characterised by a large, if not 100%, allocation to passive global equity. Among the catalysts sparking these changes: a desire for greater diversification, an improvement in risk-adjusted returns and the ability to mitigate downside risk should equity markets face more turbulent times.
One such approach—alternative risk premia (also known as alternative beta) strategies—is emerging as a powerful tool to bolster the risk-return profile of the default strategies in DC plans. Offered in lower cost, liquid and transparent vehicles, these strategies gain exposure to risk premia that arise from behavioural biases, structural constraints or rational risk preferences. With very low correlation to traditional asset classes, alternative risk premia strategies can improve the overall risk-return profile for end investors by providing a more diverse risk factor profile. In short, they act as a different driver of portfolio returns.
DC plans are discovering that by adding an alternative risk premia strategy they can increase portfolio efficiency by reducing expected volatility. What is less well understood: These strategies can be used effectively in the early and middle, as well as the final, stages of a plan’s glide path. In this paper, we:
- consider why and how DC plans can add alternative risk premia strategies to a DC scheme
- present modeling and analysis that show how the strategies can improve the risk-return characteristics of a plan’s default strategy and create more efficient portfolios
- explore how DC plans and consultants can conduct due diligence to best select and implement an alternative risk premia strategy
Principles of diversification
Before we explore the specifics of alternative risk premia strategies, we first revisit a foundational principle of asset allocation: diversification. The benefits of diversification are clear and intuitive, and they have been well understood by investors for many years. Why do we diversify? Because it can reduce risk without sacrificing return. This fundamental understanding is a key component of the most basic approach to asset allocation. Investors allocate to both stocks and bonds because the two asset classes offer lowly correlated returns; mixing the two increases the probability of a better risk-adjusted return.
UK defined contribution investors have historically benefitted from diversification across stocks and bonds, but the approach to diversification has often been quite blunt. Typically, we have seen an allocation that is 100% invested to passive global equities in the ‘growth’ phase; it then shifts to include more fixed income in the later phases and concludes with a portfolio, invested primarily in cash and Gilts, that is similar to an annuity-backing portfolio.
DC plans began to introduce multi-asset portfolios in the early and middle phases of the glide path, principally to help lower volatility. In the wake of 2015 regulations that gave pension savers more freedom to manage their retirement funds— previously most members were directed to buy an annuity when they left the workforce—many DC plans shifted their asset allocation to extend the use of multi-asset portfolios, known as diversified growth funds (DGFs), through to later phases of the glide path, right up to retirement.
EXHIBIT 1 presents a typical UK DC plan asset allocation. In the early phase of the glide path, with more than 25 years to retirement, a typical allocation is 100% global equity. By the late phase, with less than 10 years to retirement, the portfolio is 25% global equity, 25% DGF1, 37.5% Gilts and 12.5% cash.
A typical UK DC plan asset allocation shifts from 100% global equity in the early phase to primarily fixed income in the late phase
EXHIBIT 1: THREE-PHASE DC PLAN GLIDE PATH WITHOUT ALTERNATIVE RISK PREMIA
Source: J.P. Morgan Asset Management. For illustrative purposes only.
Alternative risk premia and factor investing
In recent years, DC plans and their consultants have realised that there is room for improvement in the default strategy’s risk-return profile, in particular in the early phase, in which many DC plan members are exposed solely to equities. Although diversified growth funds provide some diversification for members in the mid and late phases, increasingly DC plans are also turning to alterna¬tive risk premia strategies to achieve that important goal.
To understand how alternative risk premia can further diversify DC plans, it’s helpful to first consider what these strategies look to achieve. An alternative risk premia strategy is a rules-based strategy that seeks to provide exposure to the portion of returns, across asset classes, that are attributable to systematic risks (beta) vs. idiosyncratic manager skill (alpha).
Since the 1970s, market participants have recognised common factors in traditional investments such as stocks and bonds. Investors understand that by holding a diversified cross-section of stocks or bonds, they are exposed to a risk, and over the long term they expect to be compensated for that risk exposure. We refer to these factors—such as equity beta, duration and credit—as ‘traditional factors.’
As academics and practitioners have acknowledged, additional sources of return beyond these traditional factors—alternative risk premia—can also be accessed via a systematic, rules-based approach that takes both long and short positions. Alternative risk premia can be identified across asset classes—equities, fixed income, currencies and commodities. Examples include:
- Value: Less expensive securities tend to outperform more expensive securities
- Momentum: Securities whose prices have gone up (or down) tend to continue to go up (or down)
- Carry: Higher-yielding securities tend to outperform lower-yielding securities
- Quality: Higher-quality securities tend to outperform lower-quality securities
Benefits of diversification
Strategies that provide exposure to alternative risk premia such as value, carry, momentum and quality are long-short in nature, as they look to most efficiently capture the premia while limiting exposure to traditional market betas. These alternative risk premia offer a number of benefits, primarily:
- Alternative risk premia can provide positive risk-adjusted returns over time and across various markets and time periods.
- Alternative risk premia are lowly correlated to one other.
- Alternative risk premia are lowly correlated to traditional asset classes.
Another benefit, which is especially important for DC schemes: These strategies can be accessed via transparent and cost-effective vehicles.
EXHIBIT 2 shows the correlations of alternative risk premia and traditional asset classes.
An effective strategy will look to invest in alternative risk premia that have a low correlation to traditional asset classes
Exhibit 2: correlation matrix: traditional asset classes and alternative risk premia
Source: Bloomberg, J.P. Morgan Asset Management; analysis period: January 1998–December 2017. For illustrative purposes only.