Supplements » Multi-Asset 2018

MULTI-ASSET FACTORS: Factor challenge

Roulette_wheelFiona Rintoul asks whether factor-based multi-asset funds have become a major growth area in asset management to the extent that they present a challenge to incumbent funds.

“The rise of factor-based approaches to multi-asset investing is a disruptive event for both traditional multi-asset managers and hedge-funds,” says Guido Baltussen, head of the quant allocation team and lead portfolio manager for liquid alternatives and multi-asset strategies at Robeco.

If this is true, then traditional multi-asset managers and hedge funds should be worried, because factor-based multi-asset strategies are on the rise. The 2017 Invesco Global Factor Investing survey showed accelerating allocations to factor investing in both the institutional and retail markets, with multi-factor multi-asset strategies considered a preferred solution by many investors. So, what is driving the growth of factor-based multi-asset strategies and are they friend or foe for traditional multi-asset funds?

First, it is perhaps useful to define factor-based multi-asset investing.

“We see factors as proven quant strategies for which academic and in-house research has shown that they generate significant and consistent alpha over deep back tests,” says Baltussen. “These established factor strategies drive our positioning decisions and are the main source of alpha within our multi-factor multi-asset quant solutions.”

At NN Investment Partners, the exact application of factors differs per investment team and strategy. Some use factors to support investment decision-taking or for risk and performance monitoring, but NN IP also manages pure, systematically managed factor-based funds, covering asset classes such as corporate bonds and commodities, as well as multi-asset. In the multi-asset sector, it manages a factor-based absolute return fund.

“This fund harvests multiple factors across all the main asset classes, including equity, fixed income, foreign currencies and commodities,” says Willem van Dommelen, lead portfolio manager for factor investing at NN Investment Partners.

One key reason why factor-based multi-asset strategies are attractive to investors is cost. With factor-based solutions, you know and get what you pay for, says Baltussen. “With the increasing fee pressure on active managers, factor-based solutions are attractive for investors as their lower fee structure is combined with more robust and consistent return drivers,” he adds.

Some see this as part of a general awakening to the cost of active management and whether it is worth the hefty price tag.

“The growing sophistication of certain investors means they are coming to realise that much of the ‘alpha’ they were paying for with traditional fundamental managers was actually coming from exposure to these various underlying market factors,” says Andrew Dyson, chairman and CEO of QMA, the quantitative equity and global multi-asset solutions business of PGIM Inc.

In Baltussen’s view, another key advantage of factor-based multi-asset strategies is transparency.

“The multi-asset space has traditionally been dominated by qualitative active managers or by hedge funds,” he says. “In an environment with increasing governance demands, factor-based strategies provide a transparent alternative in terms of the embedded risks and the actual sources of returns you are trying to harvest.”

Inefficiencies
Factor-based multi-asset strategies are also an alternative to strategies that use passive funds as building blocks. These are obviously low cost, but, in Baltussen’s view, passive investing incorporates risks and inefficiencies of its own, which reduces alpha.

“There is a clear financial as well as fiduciary reason for factor-based multi-asset funds to grow,” he says.

This rather implies that the growth might be at the expensive of traditional multi-asset strategies, but some see the two as complementary. Traditional multi-asset approaches are simpler and provide exposure to return sources with a long historical precedent, observes Dyson, whose firm runs both traditional asset class-based as well as factor-based multi-asset portfolios. Multi-asset factor-based portfolios provide access to long/short return sources that can be driven by additional risk premia or behavioural mispricing.

“By allowing leverage and shorting, we can tap new sources of returns for our clients,” he says.

NN IP’s van Dommelen makes the point that multi-asset factor investing challenges any fund that aims to deliver uncorrelated returns. In fact, it challenges the whole alpha/beta separation. This brings us right back to the cost argument for factor-based multi-asset strategies.

“What historically was considered alpha – unique manager skill – is now partially attributed to factor premia,” says van Dommelen. “As a result, the relative performance of actively managed funds and the fee investors are willing to pay is more often assessed versus the return of factor strategies that are offered at lower cost.” In fact, you could say that factor-based multi-asset strategies don’t challenge traditional multi-asset managers at all – they just challenge the ones that don’t deliver the alpha they promise.

“There are definitely return sources out there that cannot be captured by a systematic, factor-based approach,” says van Dommelen. “When a multi-asset manager has the ability to capture this true alpha on top of the factor premia – and after costs – they will clearly have a competitive edge.”

This begs the question: what is true alpha? For Robeco (which, it must be said, does have quite a lot of skin in the game, as factors are at the heart of all its quantitative investing solutions and strategies), this is a tough question for traditional asset managers to answer.

“In most cases, traditional asset managers are not purely qualitative and also rely on decision models to drive their investments,” says Baltussen. “The human judgement overlaid on models is often put forward as a value-adding proposition. But this man-and-machine combination raises a few questions.”

The first question is about the robustness of the decision-making models in more traditional setups. While factor-based approaches are rooted in academia and “rely on robust and constantly improving research methods”, traditional models can be based on subjective assessments or even – though those days are perhaps gone – a black box.

“Sound, academically grounded, research-driven expertise carries fiduciary values for trustees,” says Baltussen.

The second question is around the consistency, statistical significance and independence of the judgmental alpha. Managers rarely disclose the performance attributed to models versus what originates from the human overlay, says Baltussen, but that is the only way to distinguish skills from luck. It can also be hard to know if qualitative views are independent of model views.

“This independence is often difficult to guarantee, either because the analyst/portfolio managers are aware of model outputs or because they follow similar heuristics,” says Baltussen.

Again, we come full circle. True, manager skill can add value. But how many managers are truly skilled? And even if they are, how can that be measured to the satisfaction of trustees? Perhaps these questions will one day be answered. Until then, the runes suggest that factor-based multi-asset investing could nibble into more traditional approaches as well complementing them.

Robust
In the medium term, certainly, a changing market environment and rising volatility help to make the case for factor-based multi-asset investing.

“Long/short factor-based multi-asset portfolios allow us to design portfolios with more diversification and better drawdown properties than traditional approaches,” says Dyson. “If stock and bond markets are challenged in the next 12 to 24 months, given the mature business cycle, we expect these new approaches to help improve our clients’ outcomes.”

Another benefit of factor-based investing at a time of rising volatility is that factors have a low correlation with traditional asset classes.

“Adding factor exposure to a portfolio built up from different asset classes will increase the robustness of such a portfolio and make its performance less sensitive to general market shocks,” says van Dommelen.

As we move into a new market phase, he also counsels against putting too much emphasis on recent history. In that time, traditional balanced funds performed well, supported by declining rates and rallying equity markets.

“By putting too much emphasis on this strong performance, investors tend to underestimate the embedded risks of these strategies and see less need to improve diversification,” says van Dommelen. “We therefore believe that an environment with more volatility will trigger a further increase in demand for all-weather multi-asset multi-factor offerings.”

Factor investing – and within that, factor-based multi-asset investing – is relatively new. Many perceive it as offering a third way between passive and active investment that helps investors to balance return expectations and increasingly onerous regulatory and governance requirements. Others see it as a useful portfolio diversifier.

The future of this segment of the investment market, which has been boosted by advances in data and technology, will depend on how it develops from here. Baltussen, for example, notes a need to catch up with more traditional approaches in the increasingly important area of sustainability.

“Probably one the biggest trends in the coming years will be the ‘sustainabilisation’ of factor-based multi-asset solutions,” he says. “While traditional asset managers have already taken steps into that direction, the factor-based houses need to catch up.”

The research-based approach of factor investing, which can be costly, may also require a certain industry-wide cooperation that is not entirely a given.

“Ultimately,” says the Invesco Global Factor Investing survey, “the growth and improvement of factor investing strategies is dependent on the industry’s commitment to its research origins, and the sharing and application of its findings.”

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