Dmytro Sheludchenko of Sweden’s AP1 buffer fund explains how it constructs and manages its factor-investing portfolios
We have allocated to factors, or risk premia, for many years, but since I joined the organisation five years ago our engagement in this area has become even stronger.
Our belief is that by looking at the markets through a risk premia lens, our decision-making process becomes more robust than if we were only considering asset allocation. We have both internally and externally-managed portfolios.
One of our internal portfolios has the objective of extracting the low-volatility risk premia from the equity market. Low volatility is not among the factors originally described by Eugene Fama and Kenneth French in their research in the early 1990s. However, academic evidence that low-volatility stocks tend to outperform has emerged in more recent times.
We have also built internally-managed portfolios allocating to the classic factors such as momentum, value and carry. In this case we buy indices rather than single stocks.
In cooperation with investment banks, we have built portfolios which allocate to classic and alternative risk premia across asset classes including currencies, rates and equities. We design the portfolios but outsource the implementation to banks, which customise their existing products according to our needs.
One of the alternative risk premia we allocate to is volatility. The strategy consists of taking advantage of the fact that expected volatility is usually lower than realised volatility.
When we launched our risk premia strategies, we wanted to do a bit of everything and experiment on different factors. As time progressed we realised that the most effective way was to concentrate on factors with desirable properties that will enhance the risk exposure of our overall portfolio.
Our portfolio is highly diversified as it invests in asset classes from fixed income to private equity. We have been moving towards a more focused risk premia allocation, which we feel will add value to the broader portfolio instead of just extracting value from factor investing in general.
There are challenges with low-volatility factor investing. External providers of low-volatility strategies often offer long/short portfolios that attempt to render the portfolio market neutral. We do it in a long-only format. By nature, the realised volatility of our portfolio will be lower than the index. Over the long term we can expect to outperform the index, for instance by generating a higher Sharpe ratio.
However, in total return terms we might lag the index quite significantly, precisely because the portfolio has a lower risk exposure than the index. Therefore, in order for us to obtain desirable properties, a stringent risk-management framework is needed.
There is still a huge debate on how to measure factors, particularly in the equity space. Factor measurements is one of the most complicated questions. The choices one makes in terms of factor measurement will directly influence the outcome of the strategy. The number of different outcomes and the dispersion between the outcomes is large. The value factor is the best example. How one measures the value factor has a significant impact on the future performance of your portfolio. In other asset classes, such as currency, the variability of outcomes is less pronounced.
“There are challenges with low-volatility factor investing. External providers of low-volatility strategies often offer long/short portfolios that attempt to render the portfolio market neutral. We do it in a long-only format”
With value and other factors, I am more inclined to aggregate different measures of factors rather than use single definitions. No definition of value is necessarily better than another, because they all attempt to achieve the same goal, which is to identify companies whose intrinsic value is higher than the market value. I tend to believe in the wisdom of crowds: many people might say different things, but on average the crowd should be correct.
Combining different measures of a factor should provide a better picture. Building our factor strategies has not been especially difficult from a technology point of view. The availability of powerful computing technology has improved today compared with two decades ago.
We hold all the databases internally and there has been no extra load on our IT systems to manage our factor strategies. Plus, our strategies involve very long holding periods, so we do not need the added computing power that might be needed for strategies that might require more frequent trading.
From a governance perspective, our use of factor strategies has not been a particular burden, either. We have an efficient governance framework in place and the power of risk premia is part of our organisation’s investment beliefs. The knowledge and understanding of these strategies within the organisation is broad.
However, we strive to be as transparent and open as possible with our board. We always present all the possible outcomes of our strategies and we are open in what we are trying to achieve, and why that is good for the fund.
Our goal is to be transparent and clear within the organisation and with our board in terms of which properties these investments carry.
Interview by Carlo Svaluto Moreolo