Feature
where a return is coming from. “This approach helps investors understand what they are getting into, in terms of strategy,” says Vitali Kalesnik, head of research and business strategy in Europe for Research Affiliates. “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.” 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 those who do not buy into the overall investment approach should realise that the factors are working whether they believe in them or not.
SOME ARE MORE EQUAL THAN OTHERS
Another point to recognise is that while all factors are created the same, they are not used uniformly. “Various managers will capture different factors using different signals, so it is important to know what they are doing and how these factors behave,” Carver says. “Some managers might capture the factor on a price-to-book measure, which could give a bias towards a certain sector. These incidental exposures are not trivial.
It is
important to understand this.” Gosvig says that if pension funds go to 10 managers running momentum strategies, they must realise that the strategies will all have different outcomes in the short and medium term. “They might all be thinking
the same, but there are differences in all their implementation,” he adds. Equally, ATP does not implement factors in the same way over short and long-time frames.
“In the short term we have to adjust for dif- ferent volatility,” Gosvig says. “In the long- er term we evaluate the strategies and make our decisions and change the metrics as we need to.”
There are increasing numbers of tools for investors to break down their holdings and see which factors are present and how they have moved across an entire (non-risk-fac- tor-labelled) portfolio – and within the mar- ket itself.
“There are five or six factors that seem to be the most entrenched or verified by academic research, but we should expect that to change,” Idzal says. “Markets change, pref- erences switch, technology moves things.” For example, academics have started to ask whether the value premium is still around, at least in its accepted form. “Should we expect those measures to still be applicable to firms such as Amazon, which have much different capital struc- tures to firms who were dominating in the days when most of the research on these factors was done?” asks Idzal.
IN TOO DEEP
The fact that these drivers may fall by the wayside and be replaced by others is a key point to remember, as using the term “risk” for each side of a pension fund’s invest- ment equation has sometimes confused and turned off investors.
There is a danger that they think the risks within a portfolio must somehow link with those on the other side of the balance sheet – the liabilities – which is not the case. The whole of ATP’s DKK785bn (£90.7bn) is not matched to the longevity expectation and retirement income needs of Denmark’s 5.7 million citizens. Gosvig says that ATP has split its assets into two buckets: hedging and investment portfolios. “The hedging portfolio is a bond and swap portfolio all matched to liabilities. With the investment bucket we are free to do what we want.”
If the fund was not hedged in this way, its risk budget would be eaten up almost immediately. Instead ATP can use leverage on its investment portfolio to make the best returns it can. “By using it to match our liabilities, we can make the most of the rest of our money by using it as a risk budget for rewarded factor risk,” Gosvig says. “The best way to do this is to diversify, combining the different betas and other factors. It improves our sharpe ratio and lowers the risk overall.” But while a better sharpe ratio and liability hedging seems like the Holy Grail, it comes at a price to do in-house. “Factor
investing is complicated and
requires sufficient investment and trading skills and a sophisticated middle/back office to run internally,” Gosvig says. “Find- ing them externally can be costly. The best place to start is with mandates with a mix- ture of market beta and other factors.” Some fund managers have already begun to
launch fixed income factor-based
approaches, but don’t expect the strategy to catch alight as it has with equites. Apart from differences in the drivers and how they are captured, the economies of scale work the opposite way in fixed income to equities, according to Kalesnik, which could be a major barrier to the approach’s transfer. “Larger active equity managers struggle to get performance,” he adds. “In fixed income, this is not the case. “Larger managers can earn alpha as the sector is less uniform and the manager can make a range of selections of securities.” Additionally, despite a push to trade fixed income on exchanges by international reg- ulators, much is still bought and sold over the counter.
“There are large bond houses that have huge legacy products in fixed income, and they are not likely to lose many assets to this approach,” MSCI’s Carver says, adding that analytical tools will help investors bet- ter see what they are paying for. For Idzal, while take up of the approach has soared since the crisis, it is still early days. “We are in the teenage years in terms of helping investors get better transparency and choice – and there is a lot more to go.”
September 2019 portfolio institutional roundtable: Factor investing 33
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