12 May 2020
Over the past decade, insurance companies have operated a massive shift from actively managed strategies to passive ones. Going passive in equity markets proved to be a cost-effective solution to harvest market returns. Yet going passive in a world shaken by Covid-19, which will likely be characterized by low expected returns for equities and an increasing need for integration of sustainability in equity portfolios, may prove suboptimal.
For insurance companies, the move towards passive has often been encouraged through their strategic asset allocation processes typically using common equity indices as a benchmark.
Going passive for their equity allocation has therefore been a natural step, as they seek more cost-effective solutions for their investments.
However, while passive products based on public indices have their merits, they also present serious drawbacks. For one, index-following strategies tend to lag their benchmark once management fees and transaction costs are taken into account.
Moreover, the transparency they offer comes at a price for investors, as other market participants actively arbitrage index additions and deletions. Also, these strategies often ignore sustainability considerations.
In a low-yield environment, where the performance of equity markets is also expected to be weaker in the coming years, the ability to generate outperformance becomes even more important. This is encouraging a growing number of insurers to move to a middle ground between passive and traditionally active products, often called enhanced indexing.
A quant-based alternative to passive investing
The concept of enhanced indexing is based on the vast amount of academic research documenting factor premiums in both developed and emerging equity markets. The idea is to systematically capture the market return and, in addition, benefit from some of these premiums, such as value, momentum or quality, with explicit decision rules.
It is possible to target a combination of specific factor premiums while keeping tracking error controlled and costs low, with fee levels close to those of passive investment products. Such characteristics explain why enhanced indexing portfolios can be viewed as an attractive alternative to core passive equity allocations.
The starting point is determining the benchmark. This can be a market capitalization-weighted index, an equal-weighted index, a smart beta index or even a very diversified ESG index. For example, our standard enhanced indexing strategies are based on the MSCI, S&P or FTSE indices. Next, an investable universe will be defined that may include some off-benchmark stocks.
Then, a slightly higher weight is given to stocks with attractive stock characteristics, while a slightly lower weight is given to those with unattractive characteristics, based on the outcome of a proprietary quantitative stock selection model. This enables an investor to potentially harvest stable outperformance after costs, with a low tracking error, as only very small deviations are allowed.
Because deviations from the benchmark are limited, we also ensure that we maintain the portfolio's exposure in terms of individual countries, sectors or stocks close to those of the broad market index. In this way, enhanced indexing portfolios aim to be broadly neutral in terms of sectors, industry groups, regions, countries and beta, relative to the benchmark.
Highly flexible and customizable solutions
Moreover, the flexible nature of the portfolio construction algorithm makes enhanced indexing especially suitable for insurers. With their very specific objectives and constraints within their investment portfolios, the flexible setup of these strategies means they can be tailored to investable universe, risk-return profile or sustainability.
For example, it is possible to customize the carbon footprint of an enhanced indexing portfolio whilst still capturing the majority of investment opportunities as shown by a conventional multi-factor model. This enables insurers to make a large step forward in decarbonizing their investment portfolios without significantly sacrificing investment returns.
Altogether, enhanced Indexing solutions represent cost-efficient building blocks for both the unit-linked and the balance sheet equity allocations of insurers. Given their adjustable tracking error of between 0.5% and 4%, they tend to be used as core equity holdings, thereby replacing traditional allocations to passive index funds or ETFs.