Alfred Slager, professor of pension fund management at TiasNimbas Business School at Tilburg University in the Netherlands, has set out an eight-point checklist for institutional investors considering a factor-based approach to portfolio management or investments in smart beta.
Factor investing takes into account risks that stretch across different asset classes – from economic growth and political uncertainty to credit, duration, size, value, volatility and illiquidity – to achieve more robust portfolio diversification and to refine exposure to factors with desirable risk/return characteristics.
Slager – presenting the findings of a study into European pension funds’ awareness of and approaches to factor investing at a 31 January seminar organised for clients by Robeco in Rotterdam – laid out the advantages in terms of better diversification, improved benchmarking of active managers and more cost-effective exploitation of systematic market risks, but emphasised the governance challenges that face investors trying to adopt these new methods.
“There is a lot of interest in these processes but also a lot of uncertainty about how to embed them into the portfolio,” he told the delegates, which included many leading Dutch and Belgian pension funds. “If factor investing is so compelling, how come every pension fund isn’t doing it? What are the barriers and challenges?”
Slager reported three basic ways in which investors were implementing some of the ideas behind factor investing.
The first approach involves leaving the portfolio as it is, with the fund using the additional insights about exposures and diversification.
The second identifies existing factors tilts and corrects them to some extent to introduce a more desirable mix of factors.
The third approach aims to create a portfolio that is unconstrained and fully factor-optimised.
“Today, pensions funds that have taken any steps at all have usually taken steps one and two, and dream about step three,” he said.
But Slager’s survey of the latest pension fund annual reports revealed almost no mention of factors or factor investing, suggesting that even many of those investors pursuing these ideas do so without fully considering the theoretical framework, or struggle to communicate that framework to trustees and members.
“Trustees have pointed out to me that the level of abstraction we are dealing with is one hurdle,” explained Slager. “It is difficult enough trying to describe what equities and bonds do in their portfolio; if we move up a level and begin to describe term risk, volatility risk and so on, that is a considerable challenge under a governance structure that requires much greater transparency and communication that it has in the past.”
This is important, Slager added, because investors need to establish their beliefs about whether individual factor risks are rewarded over time, how long it can take for those risks to be rewarded, how well the resulting risk/return characteristics fit with their own particular objectives and constraints, and how best to benchmark performance.
Many of these points are still the subject of academic debate, and can be significantly affected by real-world investing constraints such as transaction costs or restrictions on short selling.
“The fact many of these factors appear to have statistical persistence over time is all very well, but, to communicate properly with clients, we also have to know what realistic expectations we can have about these factors, how reliable they are and, most importantly, whether we have a persuasive economic story that makes sense for them,” Slager said.
Even once these investment beliefs are agreed and communicated to members, factor investing introduces a range of potentially complex active investment decisions, and investors need to consider where in their governance structure those decisions should be taken and monitored.
“We therefore tried to condense our findings from discussing these issues with pension funds into a checklist that would be helpful once an investor has decided to use factors in its model,” said Slager.
His checklist had eight points:
- Treat factor investing as an investment belief and an investment paradigm, rather than merely a technique
- Educate stakeholders to a full understanding of factor investing
- Establish common definitions for the terminology used with trustees and members
- Focus on appropriate benchmark construction
- Regularly review the economic rationale for chosen factors
- Be consistent in implementation
- Recognise that these are active choices that require an active stance
- Decide early on how static or dynamic allocations to factors will be