All change: the New Mexico State Capitol building where the decision was made to move funds into smart beta © Getty
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When the New Mexico State Investment Council decided earlier this year to replace two large-cap active fund managers with smart beta mandates worth a total of $2.1bn, it was following in the footsteps of many other institutional investors.

Investing in index funds that weight the indices they follow by factors other than market capitalisation is growing more common in large institutions.

Despite concerns that increased popularity could lead to so-called crowding and a fall in performance, institutional investors do not appear to have been deterred.

Nearly half of institutional investors surveyed reported an allocation to smart beta in 2017, up from 36 per cent in 2016, according to FTSE Russell’s global smart beta survey of 194 asset owners.

The strategies represent a modest proportion of overall institutional allocations, but their rising popularity is due to an improved understanding of smart beta, analysts say.

Ana Harris, head of equity portfolio strategists, Emea, at fund manager State Street Global Advisors says Australian and Asian investors, for example, are becoming more comfortable with using “multi-factor strategies”, which consider several investment tilts at the same time.

Popular factors include momentum, which is based on the theory that rising and falling assets will continue their trading direction, at least for a while.

Europe has experienced the biggest take-up. Sixty per cent of European asset owners reported some allocation to smart beta in 2017, compared to 52 per cent in 2016, according to the FTSE Russell research.

Julien Barral, equities specialist and director, public markets, at consultancy bfinance, notes that some early adopters, such as institutions in the Netherlands, have been refining their approach to the space.

This means, as the investors became more comfortable with these strategies, they have moved away from straightforward, passive approaches to more sophisticated products developed by specialist quantitative managers, Mr Barral explains.

However, he warns that a number of strategies are new and have not experienced a full market cycle. “Simulations will never show a bad track record, therefore clients need to be even more sceptical.”

Eric Shirbini, global research and investment solutions director at smart beta index provider ERI Scientific Beta, says that he has also seen institutional investors moving allocations away from active managers, as well as from some cap-weighted passive allocations, and placing them in smart beta.

An advertisement for QSuper, a superannuation fund with an in-house quant team

In-house capability plays an important role in how institutions approach smart beta. John Belgrove, senior partner at Aon Hewitt, the consultancy, says some of the larger superannuation funds such as QSuper in Australia have their own in-house quant team that can create a smart beta equity benchmark and manage an allocation of assets in line with those targeted returns.

The €3.3bn ($3.9bn) Stichting Pensioenfonds TNO, the pension scheme for the Dutch Organisation for Applied Scientific Research, added two new smart beta managers to its portfolio in 2016.

“Traditional active management for equities is not so popular in the Netherlands because of cost and regulatory issues,” says Mr Belgrove. Smart beta, on the other hand, is viewed as a “low-cost alternative”.

Mr Barral thinks investors “have generally adopted a cautious approach by allocating a relatively small portion to the space initially”.

Ms Harris echoes this view, noting that there have been “very few cases where we’ve seen investors completely overhaul their asset allocation . . . in most cases [it involves taking] small steps”.

She adds that the attraction of weighting indices to highlight environmental social and governance considerations in relation to smart beta is also growing more popular and more clients are asking about applying an ESG strategy in discussions about asset allocations.

While smart beta funds are gaining traction with retail investors, the strategy has really taken off with institutional investors. Some smart beta strategies might go through extended periods of underperformance relative to capitalisation-weighted approaches if they are weighted to emphasise characteristics that will deliver in the long term, such as strong balance sheets. “This may not suit the expectations of a retail market that typically shows less patience,” Mr Belgrove says.

“Institutional investors, like pension plans, will have more resources and ability than retail investors to incorporate smart beta strategies into a wider portfolio that balances the active risk budget.”

Copyright The Financial Times Limited 2017. All rights reserved.