Funds Europe and Style Analytics explored how investment factors can be used in performance analysis, helping asset owners chose managers, and helping asset managers demonstrate their value.
A greater awareness of ‘investment factors ‘ – the common, sometimes unintentional, drivers of investment returns – has grown up in the past two to three years in parallel with the publicity given to ‘smart beta’ investing.
It has become a talking point about whether strategies that leverage investment factors should be priced more cheaply in line with ‘beta’ products, or whether asset managers are showing skill in identifying them.
In February, Funds Europe held a webinar – in association with Style Analytics and with the participation of Redington, an investment consultancy – to explore how fund managers and asset owners can apply “factor analysis” when making sense of investment performance, manager value, and fees.
Bernie Nelson, president for the North America region at Style Analytics, joined Funds Europe along with Nick Samuels, head of manager research at Redington. Style Analytics has pioneered the ‘Skyline’ approach to portfolio factor analysis, while Redington uses factor analysis as part of its wider criteria for investment manager selection.
A poll conducted during the webinar reflected the importance of the topic as 83% of participants said they always or often discussed factor analysis at manager review meetings.
An investment factor was defined by Nelson as a common driver of security returns that can be measured across all companies. But how are these return drivers analysed? In Style Analytics’ case, the firm has pioneered the ‘Skyline’ approach, which focuses on a portfolio’s forward-looking structure and its current factor intention.
“In this holdings-based approach, well-researched fundamental market metrics are standardised and compared between a portfolio and its benchmark to create style tilts,” Nelson explained, noting that the metrics also take account of stock diversification. This helps illuminate the significance of the style, or factor, orientation.
With the rise of factors, such tools have become increasingly important. Samuels, who has been researching equity managers for 12 years, has seen a steady increase in factor usage since the early 2000s. One reason is cost. More traditional fundamental managers typically have higher fees than factor-orientated approaches – but some of them have not had good returns in recent years.
“For the last five or six years, we’ve been using factors as a very critical component of our process,” Samuels said. “What we’re trying to do is understand the fund manager’s investment philosophy and figure out how that translates into the portfolio.”
If a manager articulates a ‘quality’ investment philosophy, for example, then Samuels wants to see positive tilts to quality factors when he uploads the holdings into Style Analytics. If the qualitative and the quantitative can be married, a manager can be bucketed and compared with other, similar managers.
The next stage is to see whether the manager has added value over and above the factor tilts.
“For quality, we could combine return-on-equity and low debt,” Samuels said. “We want to see that they have added value over and above that pure factor. If they have, then things are starting to line up.”
Checking for style drift
These tools are then also used in the monitoring process. The factors provide a lens that allows consultants to check for style drift.
“We are looking for consistency,” Samuels said. “Each month as we get the holdings through, we can check that the manager is still shaping the portfolio as expected.”
These same tools are also useful for looking at how managers compare, Nelson noted. “One of the trade-offs is that everyone has a different philosophy. How do we put those on a neutral playing field to compare? Style Analytics’ tools enable that comparison even if the wrappers are different.”
In response to a question about applying factor analysis to multi-factor funds, Nelson observed that all funds are in some ways multi-factor funds. If a product proclaims a particular focus, part of the risk management and due diligence around the product should be to consider what other factors are present.
“It’s useful to put every product on a similar framework so you can compare them,” Nelson said. “It’s all about looking across multiple factors and categories.”
Samuels added that the Skyline approach offers a way of checking whether the factors in a multi-factor approach shine through. If they do not, then that becomes a line of questioning for the manager.
“In multi-factor, hopefully one factor doesn’t dominate,” he said. “You can find that out with this product.”
Disappearing premia
An audience question then brought up the issue of whether factor premia would disappear if everyone is aware of them. For example, the questioner said, hasn’t value been struggling for over a decade? Samuels agreed that value had had a tough decade but said it wasn’t because people had overbought it.
“If anything, it’s because people have abandoned the factor,” he said, noting that value is a factor that goes in and out of favour, and often does well again after being out of favour for a while.
Another audience member raised the issue of whether environmental, social and governance – or ESG – could be viewed as a factor and, therefore, potentially a driver of alpha.
Style Analytics was looking at the performance attribution of those factors, Nelson said, and he noted that ESG was a nascent field but an important one, given that products claiming ESG qualities were growing in number.
Another audience question highlighted the issue of how to view an asset manager who has no specific tilts and who claims to have a non-traditional, growth-oriented strategy.
Samuels observed that this could be a good thing. “If they’re doing something that can’t be captured by a simple factor, then that’s a potentially an interesting manager, because whatever their alpha source may be, it’s not yet been systematised.”
Nelson added that asset managers could possess a type of stock selection process that does not culminate in style bias or factor tilt and said that performance attribution charts could give this kind of insight.
Looking at Style Analytics’ insights of investment performance, Samuels was asked what kind of results from analysis of performance might lead a consultant to terminate a manager’s contract. He said this would come down to style drift or the ceasing of ability to add any value over and above the style factor.
“Nowadays, with smart beta and simple multi-factor combinations, a fundamental manager needs to deliver alpha over and above the benchmark and the simple style factor,” he said.
Data from the analysis of investment factors can help asset owners and fund managers themselves to understand whether a product genuinely adds value, Samuels said. This in turn could give them a justification when explaining pricing when it can be proven that a particular products adds value, and the impetus to discontinue or change products that don’t add value.
You can view “Using Factor Analysis in Manager Selection” on our webinars channel: www.funds-europe.com/webinars-channel
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