Just as innovation is driving rapid change in our lives, it is changing how we invest. Many investors are facing challenges because the traditional ways of sourcing alpha are no longer sufficient to help meet investment goals. As asset managers, it is imperative we find and adopt new sources of alpha made available through advancements in data and technology.
One such innovation is factor-based investing, and the development of exchange-traded funds, often referred to as “smart beta”. Factor investing seeks to provide access to broad and historically persistent drivers of returns within and across asset classes, markets and countries, and continues to grow rapidly. It should be noted that the diversification and asset allocation benefits sought by these strategies is not guaranteed, and do not ensure a profile or guarantee protection against loss. In 2016 they experienced global flows of $55 billion and reached an assets under management (AUM) of $330 billion. There are currently 955 smart beta ETFs globally.1
The investment paradigm in the minds of many has shifted, from an approach of investing measured against a strict benchmark, to more outcome-focused investing. Investors, therefore, are placing a premium on managers that actively manage factor exposures and generate returns in excess of what they can earn themselves by holding static factor positions via ETFs.
Against this backdrop, let’s walk through a few examples to demonstrate how asset managers can incorporate factors to express investment views and complement existing holdings.
Express investment views
Economic intuition and empirical evidence show that factor premiums vary over time. Because each factor is driven by different phenomena, they tend to outperform at different times. Our research2 indicates that it is possible to tilt factors and seek incremental return by over and underweighting select factors, relative to others, while maintaining long-term exposure to all factors.
Let’s consider five equity style factors: value, size, momentum, quality and minimum volatility.
For each factor, we consider four indicators (see Chart 1) to determine whether to tilt towards or away from the factor. While each of the four indicators is available on its own, we believe it is more effective to combine these four insights into a composite indicator. This tells us whether to under, over or neutral-weight the factor relative to other factors, while still maintaining exposure to all the factors over time.
1 - Source: BlackRock as at 31st December 2016.
2 - Source: BlackRock and MSCI as at 30th September 2017.
❱ SouRCE: BlackRock as at 31st Dec ember 2016. F or illustr ative purposes only.
Many investors are already engaged in factor rotation, although they don’t necessarily think about it in that particular way. Every time an active manager adjusts an equity allocation to get more defensive – either through sector rotation or country selection – they are also adjusting their factor exposure. Most portfolio managers think in terms of cyclical versus defensive exposures, or emerging versus development, but it is important to recognise that when one modifies those, one is also adjusting the quality, momentum, value and volatility exposures.
Complement existing holdings
Persistent style factors have delivered returns in excess of the benchmarks over time. Nonetheless, there are times when certain factors are in and out of favour and it should be highlighted that these types of strategies do not guarantee returns over time.
Strategies that focus on one or two factors are at risk of underperforming in certain market conditions. Take the value factor, relative to momentum. As shown in Chart 2, excess returns are negatively correlated, highlighting the opportunity of not allocating to a single factor, but combining exposures in an effort to prevent large swings in relative performance.
Why consider factors?
Active management is all about having an informational edge. Through data and technology, factors are now packaged in an efficient wrapper that allows investors to integrate these seamlessly into their investment processes. At the very least, thinking about a portfolio through a factor view may bring new clarity and focus to their process.
❱ Source: MSCI as at 30th June 2017. Momentum represented by the MSCI USA Momentum Index, Value represented by MSCI Enhanced Value Index.
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