Feature | Factor investing
Replacing expensive active management fees with a passive, factor-led approach has cut pension fund outlay considerably, for example, but cost is not the only thing pull- ing investors towards this once
niche
approach. FEEL YOUR WAY
It is a more instinctive way to invest, according to Tom Idzal, head of North American sales at research firm Style Ana- lytics. He says that until the relatively recent acceptance of risk factors, investors had been given the simple choice of coun- tries, regions or sectors to divide up their stock portfolio.
Mads Gosvig, ATP’s head of investment strategy. “Our approach is to look at risk from a factor perspective when we invest in equities and fixed income. This helps us identify risk related to market beta as well as non-market beta.”
The fund can see what is driving the return of its securities; whether they are being pushed up or down by something other than the will of the market. “We want to separate the market beta from the other ‘smart factors’,” Gosvig says. “We have labelled the non-market beta, or ‘smart factors’, our ‘other factor’.” With this ‘other factor’, the team constructs different trading strategies – long/short, for
the best we can get, but it is inherently dif- ficult to use it to predict.” Multi-factor funds address this by bundling many streams together and switching the weightings between them depending on which is forging ahead as others fall back. This can be helpful, according to Idzal, but it should not be used as a method to predict future returns. However, even this is only the case – on an industry level at least – for equity investing. The billions of stocks and shares that have changed hands each day over the past 100 years, have built up a solid wall of data. For fixed income, which is traded much less frequently, this information is not available in such great quantities, but there are plenty of people working on it.
It is impossible to manage your
portfolio exposures unless you know your factor exposures. Mark Carver, MSCI
“Factor investment is an acknowledgement of the common drivers that go across sec- tors and countries that tap into something intuitive,” Idzal says.
Risk aversion, a preference for quality, or buying in early to a growth story “are com- mon characteristics of consuming some- thing that is human in nature,” he adds. They can feel more natural than the tradi- tional investment options of choosing a col- lection of securities based on arbitrary loca- tion, size or what a bank has decided sits together in a package. Investors actions are all driven by some- thing, so it might make sense that compa- nies, which are all made up of people, are driven by something, too.
This method of investment has elevated Denmark’s national pension fund, ATP, to the upper echelons of the pension hierar- chy. Even amid the turmoil of the financial crisis – and the gloom beyond – it has gen- erally stayed ahead of its return targets. The investment team applies the approach across its entire liquid asset portfolio, says
40 | portfolio institutional | April 2019 | issue 83
example – across asset classes, including equities, interest rates, currencies and commodities. “We invest in global securities and can position our portfolios towards being long risk factors,” Gosvig says. ATP runs 85% of its money internally, rather than through third party managers. “This way we can be in control – and we don’t want to pay external management fees for something we can do ourselves,” Gosvig adds. But even ATP realises that factor investing is not the answer for the whole spectrum of assets. Its illiquid portfolios, including pri- vate equity, are held in the traditional way. “We hold them on a long-only basis and focus on other characteristics when con- structing the portfolio,” Gosvig says. There are other limitations with a factor approach, too. “It cannot predict,” Idzal says. “It is built on the shoulders of lots of historical data, pat- terns and strong historical relationships, put together by top academic minds, so it is
UNDER THE HOOD
What this data can do, however, is hold a lens up to an existing portfolio to gauge where a return is coming from. “This approach helps investors understand what they are getting into, in terms of strat- egy,” says Vitali Kalesnik, head of research and business strategy in Europe for Research Affiliates. “A lot of active manag- ers can be selling a promise. Looking at the factors, you can try and understand what will, and will not, deliver.” Factors give investors the ability to detangle past alpha to see if it was produced by skill or luck.
“This is especially important in fixed income as an investor can comfortably have a lucky bet for 30 years due to very long cycles,” Kalesnik says.
Once an investor has identified where the performance – good or bad – is coming from, they are also better placed to under- stand the diversification of their portfolio. Mark Carver, global head of factor index products at MSCI, says that it shows the opportunities and the uncertainty within a portfolio. “Applying this lens is the only starting point,” he adds. “It is impossible to manage your portfolio exposures unless you know your factor exposures.” Even investors who do not buy into the overall investment approach should realise
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