Factor-based investing begins with the premise that differences in stock returns can be explained by a set of common, discrete factors or risk premiums.
Relative to a market capitalisation-weighted portfolio, a factor-based equity portfolio seeks greater exposure to stocks identified as having (being correlated with) the desired factor risks in order to produce returns that exceed market returns.
Factor-based investing employs a very different approach to those used by traditional active equity managers.
The latter traditionally conduct extensive bottom-up fundamental research on individual companies and then construct a portfolio of stocks determined to be most undervalued or to have attractive growth prospects (or some other desired characteristic; for example, defensive characteristics).
The important insight behind the factor trend is that much of the alpha generated by traditional active managers through this process can be explained by common factors, and as an alternative to intensive research, simple rules can be constructed to harvest these same factors.
One high-profile example of this insight is the US$889 billion Norwegian Government Pension Fund, which commissioned an external report in 2009 after its actively managed investment portfolio failed to meet its return target.
The report states:
“In fact, approximately 70 per cent of all active returns on the overall fund can be explained by exposures to systematic factors over the sample. It is appropriate that the fund has exposure to these factors: these are associated with risk premiums that the fund, as a patient investor, can seek to harvest over time, just in the way that, with an exposure to the market portfolio, it has sought to harvest the equity risk premiums.”
The report further stated that:
“In light of the relative importance that factor exposures already play in the fund’s returns, we suggest that the fund consider a framework that more explicitly recognises the structure of its return generating process via investment in factor benchmark portfolios.”
Subsequently, the Fund adopted a formal factor-based investing approach based on size, value and growth factors.
What a follow up report noted – and what is instructive to active managers – is that the fund’s factor approach became one facet of a multi-pronged approach, which also included security selection by way of external active managers and internal programs.
This case study helps to explain the attraction of factor-based investing to a superannuation fund.
It can, at least potentially, substitute for a large component of the fund’s active management program in a way that gives the fund more control over its investment objectives and outcomes, and more transparency about the risk and return drivers of the portfolio – attractive in the business of managing the complex, myriad stakeholder interests in superannuation fund investment outcomes.
What must also, obviously, be an attraction in this era of fee pressures is the lower cost of factor-based investing compared to active management.
There is, however, encouraging news for active investment managers: the take up of factor strategies does not necessarily mean less business but rather, as the Norwegian Fund case study indicates, a freeing up of a fund’s fee budget to seek truly complementary active management to harvest returns from specific investment insights and idiosyncratic risk.
For superannuation funds to follow in the footsteps of the Norwegian Government Pension Fund (and others) and realise this “new paradigm” of investing requires them to resolve two important threshold concerns.
First, they must have access to factor risk analytical tools and insights in order to develop a conviction about a particular factor exposure (or set of factors).
Second, fund decision-makers need to be comfortable with the potential ‘career risk’ that comes with the decision to either depart from a market cap-weighted passive approach or to substitute an active management allocation with a factor portfolio of the fund’s own design.
Neither of these threshold issues are small points.
Assuming the fund deals with these threshold issues – and some funds have – there is also an important implementation issue to address: how to ensure what the fund gets is a pure factor exposure, reflecting its conviction, without also introducing a host of other unintended risk exposures.
This mistake is easy to make if the factor implementation is dealt with too simplistically.
The answer, in our view, lies in the use of optimisation techniques to construct the portfolio and the careful setting of constraints, or risk bounds, as part of this portfolio construction.
At Parametric, we recently tested a simulated strategy that aims to achieve exposure to the value factor in an international equities portfolio.
With this example we have demonstrated a practical factor portfolio implementation approach that involves optimisation to gain high exposure to the value factor, while using bounds as a way of managing other risks relative to the capitalisation-weighted investment universe.
We constructed our investable universe by selecting large- and mid-capitalisation stock constituents of the S&P BMI Global index for developed countries defined in the MSCI World index.
Our investable universe included 1500-2050 stocks and 20-24 developed countries during the period between January 1997 and December 2015.
Three important and encouraging findings
First, we found, contrary to the traditional view that bounds are a risk management tool employed at the cost of achieving targeted returns (a necessary cost to control risks), that bounds on unintended factor exposures, critical to deliver a focused factor strategy, can improve both absolute and risk-adjusted returns.
Second, we established a hierarchy of importance in the setting of risk bounds. Superannuation funds need to be far more concerned with where stock and factor risk bounds are set, and less concerned with sector and country risk bounds, in designing an international equity factor value strategy.
Third, we demonstrated that optimisation and constraint setting offer a superannuation fund a valuable set of levers, which can be finely tuned to tailor the factor solution to the exact needs of the superannuation fund.
Factor investing creates for a superannuation fund a level of power, control and transparency that is a world away from relying on the factor exposures embedded in myriad active management strategies.
Active managers, with their skills and insights, need not be ‘crowded out’, but must be clear about their repositioning along the investment continuum.
Funds that embrace the ‘new paradigm’ of factor investing must rise to the important challenge of ensuring they get what they want, without exposing the fund to a host of unwelcome surprises in the factor solution that is ultimately delivered.
Raewyn Williams is the director of research and after-tax solutions at Parametric Australasia.
