Feature – Index funds
“The resulting momentum overinflates market values in the upswing,” he adds. “It also causes extra volatility in the down- swing, as subsequent corrections overshoot intrinsic value.” Factor investing, in contrast, focuses on value drivers at differ- ent stages of the market cycle by switching between factors. “This is deemed to offer a more robust diversification via a lower correlation among its constituent risk factors,” Rajan says. They were developed for one key reason: the recognition that traditional diversification failed when it was needed most – in bear markets – when the correlation between historically lowly-correlated asset classes went through the roof, thanks to their exposure to common risk factors.
Reasons to be cheerful
They offer institutional investors two benefits. “First, they have a more rational basis for diversification,” Rajan says. “This is especially relevant now as, with rising inflation, the equity- bond correlation will turn positive and remain high, if history is any guide. Second, the cost is much lower, so they can poten- tially offer cheap alpha returns at near-beta fees.” In addition, as most active managers have struggled to beat their market benchmarks, factor investing has appeared a more credible option for accessing alpha.
Among institutional investors, mostly large pension plans with the necessary skillset and governance structure are using them. Some are engaging in factor investing by relying on their in-house team of investment professionals.
This is evident with the €120bn (£99.9bn) Danish pension fund ATP, which uses factor within its multi-layered invest- ment portfolio. Christian Kjær, ATP’s president and head of liquid markets, enthuses about the use of factor investing. “In broad terms, the factor investing approach has been success- ful,” he says. “We have generated high, risk-adjusted returns from diversifying equities, bonds and inflation.”
Right risk Having a risk capacity constraint, rather than a capital con- straint is one reason why the fund uses such an approach. “A risk capacity constraint is important for how we have set up the investment portfolio,” Kjær says. “The task in the investment portfolio is to have as much risk in the portfolio as we feel is suitable and are comfortable with. So, getting the right level of risk is the first and foremost objective of the portfolio. We believe returns are primarily driven by risk. “Secondly, it is creating the highest risk-adjusted return. So, one is getting the risk right, and two, is getting the right risk. “The task of creating the highest risk-adjusted return is why we end up in this factor world,” he adds. “We believe it is the best strategy to achieve a high-adjusted return is via diversification.”
46 | portfolio institutional | March 2022 | issue 111
It was a cathartic moment when pension plans started looking at investing through
the lens of factor investing. Amin Rajan, Create Research
ATP has three primary factors: an equity factor with 35%, an interest-rate factor of 35% and an inflation factor of 15%. “We have what we call other factors, which has a risk strategic level of 15% – it is a lot lower at the moment – and this is where fac- tor strategies come into play in this other risk,” Kjær adds. “Here, when we have taken out everything from the traditional investments: equities, bonds, inflation and commodities, we look for these dynamic strategies to give us something extra.”
Many factors Factors come in many flavours. As well as what Kjær at ATP highlights, there are macro factors, such as GDP growth and volatility. Then there are equity-specific ones that are broken down into size, value, momentum, variance and currency. There is also a choice between bond-specific ones like capital structure, duration, credit spread and default risks. It enables pension investors to understand three things: the sources of risk and return at a more granular level, the time- varying nature of risk premia and the key drivers of correlation between all asset classes. “Early experience suggests that their returns have been more sensitive to rebalancing than the choice of risk factors per se,” Rajan says. “Even so, this risk fac- tor approach is seen as a significant advance.”
Investor development
The move to factor also comes from a better understanding of risk, notes Shaun Murphy, president of consultancy Polaris Global Advisors. “Many institutional investors have become more sophisticated and now better understand how risk factors can have an effect on plan assets,” he says. “Factor investing is an area we have increasingly seen institu- tional investors using to understand, quantify and control risk
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