Factor investment strategies are on the rise among Australian asset owners, with multi-factor strategies proving particularly attractive. However, while available research shows significant long-term risk/return benefits, implementation hurdles remain considerable and errors can be costly.
Factor investing is an investment style that focuses on selecting securities based on shared characteristics thought to drive long term above-market returns, rather than on the ‘traditional’ basis of stock specific analysis. Style factors, such as value, quality or momentum, drive returns within asset classes, while macroeconomic factors such as economic growth rates or inflation can be used to explain risk and returns across asset classes. While fundamental analysis of company-specific attributes is ideal for concentrated portfolios, factor-based analysis tends to be applied on a broader range of stocks with more comprehensive risk controls.
That’s not to say that factors cannot underperform – to the contrary, performance among many alternative risk premia products has been weak for most of 2018 with short volatility and trend-following exposures suffering in particular – but they have performed in a way that is consistent with the expected performance during sharp equity reversals, making them a more predictable investment choice.
As a general rule, a factor approach is also considered to be both cheaper than an actively managed portfolio, and more profitable than a pure beta play, at least so long as the investor is prepared to play the long game. For that reason, asset owners including the Future Fund are replacing active managers whose performance is largely dependent on factor premiums, with cheaper factor-based solutions. The fact that valuations in standard asset classes such as equities and bonds have been particularly stretched has only added further fuel to the interest in factor-based investment strategies.
Stephen Quance, Asia Pacific director of factor investing at Invesco has noticed a significant uptake in factor investment approaches among asset owners globally, and Australia is no exception. “At the core, factor investing is an advanced investment technique based on quantitative evidence-based research, so it’s generally the most progressive sophisticated investors that are most advanced in taking this up. In Australia, many of the superfunds fit that profile,” Quance said.
Indeed, a recent global factor investing study by Invesco, which interviewed 300 factor practitioners at institutional and wholesale investors found that around half of institutional investors and a quarter of wholesale investors have introduced risk premia approaches alongside their traditional asset allocation approach.
The multi-factor approach
Most of these investors applied factor investing on an asset class basis, sitting between active and passive, with newer investors and those with limited resources typically opting for single factor approaches.
However, there are also significant segments – particularly among larger investors with significant scale and lower cost ratios – that are looking to factor investing as either a portfolio risk management tool, or as a different way of thinking about portfolio allocations. These are the types of institutions that favour multi-factor approaches, which combine different factors, thereby providing for additional diversification, as well as better control of risk, factor tilting, and enhancement of performance. Customised factor strategies are used to create additional capacity for low tracking error alpha generation, while skilled fundamental managers may focus on more concentrated portfolios.
“When we’re talking to funds, the multi-factor approach is where most of the interest lies. Having a multi-factor approach makes a lot of sense particularly when you care about things like Sharpe Ratios and drawdowns,” Quance told Fund Business.
The Sharpe Ratio measures the average return earned in excess of the risk-free rate per unit of volatility, essentially telling the investor how much excess return is received for the additional volatility that’s endured by holding a riskier asset, while the drawdown refers to the peak to trough decline of an investment, indicating downside risk over a certain time period.
By being more granular, the multi-factor approach is better suited to investors that look for a more nuanced view of risk, but the increased diversification that exposure to different factors provides has also proven beneficial of late.
“Over a long period of time we tend to see that momentum and value, or momentum and quality can have some fairly negative or low correlations to each other, so if you create a multi factor strategy and you diversify across factors, the overall portfolio might have a much smoother ride,” Quance said.
First State Super is a fund with about $90bn of assets that has been allocating significantly to internal multi factor investment strategies since 2017. Eben van Wyk, portfolio manager at First State Super, joined the asset owner in 2015 to set up their active systematic process, essentially building a platform that combines various proprietary factors with customised portfolio construction to suit their fund objectives.
Like Invesco’s Quance, van Wyk favours the multi-factor approach. “In recent years, there has been this deconstruction where the building blocks of an active quant process can now be bought independently at low cost. You can buy the value factor, the growth factor or the momentum factor separately, but to me, combining differentiated factors in a smart way is still the way to go,” he said.
Shorting is not common among superfunds, and they tend to operate under many investment restrictions. A creative approach to multi-factor exposures can mean they get the best of all factors. For example, while a pure value play would include poor quality underperforming stocks, combining value, quality and momentum could allow for a more sensible portfolio, providing additional diversification and returns.
“The multi-factor approach allows you to use the best of different factor elements. You can combine different characteristics of stocks to diversify between different sources of return, whether they are alpha or risk factor premia,” van Wyk said.
To achieve this, van Wyk applies a data first, portfolio second approach. “We calculate the data that represent different factors, we combine that data, and then we construct the portfolio,” he says. Van Wyk said that the alternative – combining separate factor portfolios – is far less efficient, because it is more difficult to account for the interaction between different factors ex-post.
First State Super’s platform is now being customised to ensure factors can be combined in a way that better suits the funds’ risk profile and objectives in terms of both accumulation and retired members. “This is the really interesting part, where you can use all the tools that are available to you as a quant to build a product that’s going to suit your firm or your client. It could be the risk profile, it could be drawdowns, but it can also be about tax effectiveness or alpha,” van Wyk said.
Other funds have taken different approaches. The Invesco study cites the case of an Asian sovereign wealth fund that started out with specific single factor mandates targeting different styles such as value, momentum and low volatility and only moved towards a multi-factor approach when the fund evolved its research and better understood the correlations of different factors. The fund is now exploring a more dynamic approach to factor allocation within its mandates.
Designing a multi-factor portfolio is not without challenges, and its implementation requires more than just a decision on how to combine different factors.
Indeed, the Invesco study cited the case of a European pension fund that recently implemented a multi-factor investment approach. It found that the implementation required significant organisational changes even for small allocations. “With larger allocations to factor, this has required changes to the front and back office, as well as risk management, so it has triggered an expansion of the organisation and changes in the ways of working,” the fund said.
Further challenges were encountered from decision-making to implementation. “The theory is one thing but there are practical issues in terms of new processes and gaining acceptance in the organisation of a new way of working. Strong support from the executive management team and board was needed to overcome some of these issues,” the pension fund found.
More factors also means more complexity. To build a multi-factor portfolio you need a portfolio optimiser that not only reflects the predictions, but that also operates within the constraints of the mandate. Superannuation funds face the same challenges as fund managers when implementing investment strategies that aim for above-benchmark returns while avoiding unnecessary risks, for example controlling tracking errors and sector exposures, tax implications, stock limits and minimising unnecessary turnover to ensure transaction costs don’t wipe out the expected returns.
While by no means impossible to implement, this does require significant inhouse expertise. “The portfolio manager has got to look at the model, the ideal portfolio that is proposed by the optimiser, and work out what the situations are where the model is not going to work and whether the optimiser could be doing unnecessary turnover. You do need to have an intuitive understanding of what you are trying to achieve and what is most important before you do a trade,” van Wyk said.
Similarly, it’s important to understand the impact of a factor-based approach on the risk profile of the overall portfolio.
Invesco’s Quance said it is important to understand that factor investing is a long-term commitment. “It’s a fundamentally different approach to investment decision-making. For example, while traditional investment is typically a zero-sum game, that’s not necessarily the case in factor investing, particularly if the factor is there because it is a risk return trade-off. Instead, you have to consider other issues, such as capacity and crowding, and that in turn has implications for the due diligence you run, the skillsets required, and the systems that are put in place,” Quance said.
Of course, there’s no need for asset owners to take all this in house. It’s also perfectly possible to buy a factor-based exchange traded fund, partner with a fund manager in building customised solutions or ask a sell side bank to execute the strategy on your behalf.
As one local quant manager specialising in factor investing at a large superannuation fund told Fund Business: “I don’t think that, as an asset owner, you necessarily have to aspire to be an asset manager. You do the things that make sense to do internally, where there are big cost benefits or there is a clear IT benefit to be had, but if the external world can do it cheaper for you then it makes perfect sense to outsource. In the case of factor investing, unless you have significant benefits of scale, I’m not sure it’s worth the cost and effort required to set up a trading floor, employ the right people and run all that operational risk.”