Feature
When faced with a problem, it is tempting to look for a silver bullet.
Risk factor investing, with supporters including some of the world’s most sophis- ticated investors, has been put forward by some as such a cure-all for the funding ail- ments of pensions around the world. In the guise of smart beta, the approach has taken the equities world by storm. Most major fund managers operate strategies using factors under this terminology, with investors of all sizes and sophistication holding them in their portfolio. The next big move for the approach is into fixed income, where pension funds are increasingly holding their assets – 54%, according to Mercer’s latest European Asset Allocation survey. Some of the world’s largest fund houses are muscling in on the action, launching smart beta fixed income exchange- traded and mutual funds dur- ing the past 12 months. There are plenty of reasons behind the success of the risk factor approach, according to its advocates. Replacing expensive active management fees with a passive, factor-led approach has cut pension fund outlay con- siderably, 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. “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 driven by something, so it might make sense that companies, which are 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
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,
A lot of active managers can be selling a
promise. Looking at the factors, you can try and understand what will, and will not, deliver. Vitali Kalesnik, Research Affiliates
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 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,
32 September 2019 portfolio institutional roundtable: Factor investing
put together by top academic minds, so it is 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 during 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.
UNDER THE BONNET What this data can do, however, is hold a lens up to an existing portfolio to gauge
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