Factor investing has powered the growth of generic smart beta strategies underlying the broad ETF market. But it is entering a new phase of development that is seeing institutional investors move from studying the approach to adopting tailored versions from major investment managers offering a solution to some of the most pressing problems in pension investment management.
Investment managers with factor-investing teams are moving fast to accommodate that interest by developing more precise ways to isolate the premia that factors can provide over cap-weighted benchmarks, devising more efficient ways to harvest those potential returns, and researching more sophisticated models to determine the best time to use each factor based on market conditions and the valuation history of each factor. Major providers have dropped the generic smart beta moniker in favour of branded offerings with names like engineered equity and advanced beta. New approaches that use leverage and derivatives promise to extend the scope of customisation.
“It’s the topic we talk most about with clients,” says Lori Heinel, chief portfolio strategist at State Street Global Advisors (SSGA), which refers to its factor investing strategies as advanced beta. “Probably 70% of our conversations are about smart beta and factor investing.”
Institutional adoption of factor investing through ETFs looks set to increase in the years ahead. In a survey of institutional investors Invesco Powershares conducted during 2015, 62% of institutional users said they expect to increase utilisation of smart beta ETFs over the next three years, and 57% said they were at least somewhat likely to add such funds within that same time period, up from 46% in 2014.
One institution that recently made a big move into smart beta ETFs is the Alaska Permanent Fund Corporation, which allocated more $1bn across three new ETFs from SSGA in December. The three portfolios are designed to track the performance of rules-based indices from FTSE Russell. SSGA says the new Russell 1000 Focus ETFs are aimed at investors that want to tailor their risk and return objectives, while maintaining a core position in US equities. The factor objectives include yield, growth potential and low volatility.
At the same time, investors and providers alike are grappling with growing pains in the wake of strong uptake of factor-based strategies aimed at generating low-volatility equity returns. That’s pumped up the price of low-volatility stocks, which some market participants warn could lead to a reversal that might harm investors and take the shine off the still-nascent world of factor-based investing. But every new market faces hurdles, and so far institutions remain keenly interested.
While factor investing can achieve a number of goals, two are paramount, says Sara Shores, global head of investment strategy for risk factor strategies at BlackRock. “Seeking incremental return is always near the top of everyone’s list,” Shores says. In the prevailing low-return environment, “the notion of being able to squeeze out a bit more incremental return in a cost-effective manner is very attractive”.
As the professional discipline underlying smart beta strategies, factor investing has rapidly emerged as a remedy for what ails pension funds striving to generate returns sufficient to meet payment obligations at a time of low yields and unpredictable equity returns.
SSGA contends that institutions are already factor investors, with more than 50% of active management excess return accounted for by exposure to factors, so explicitly adopting a factor approach can increase control over results by isolating factor-based returns, or beta, and harvesting those returns at a cost below active management while increasing the return from specific asset risks.
Despite differences in providers’ preferred terminology, there is broad agreement that compensated factors are those sources of return that have been documented over time to deliver a durable premium above the return of a market cap-based index for a long time horizon, usually five to 10 years. While there are dozens of potential factors, just a few have become the workhorses for institutional portfolios, with value and low volatility currently garnering the most attention from pension funds.
Where factors can help
What ails pension funds is a perfect storm. As returns from active equity management have declined during recent years despite rising stock prices, equity volatility has increased, to the extent that sudden shifts – mostly downward – in equity valuations have left other asset classes above their targeted allocation levels in institutional portfolios. These denominator effects have knock-on implications for pension funds – forcing them to decide whether to raise allocation targets to accommodate transitory increases in the relative value of an asset class, or whether to sell assets that might be performing well.
Those issues are exacerbated in the current environment. Many pension funds, if not most, are pursuing liability-driven investing approaches, often as part of a plan to de-risk portfolios in order to ensure that assets will be sufficient to generate returns large enough – and for long enough – that sponsors and members will not be on the hook for significant additional contributions or exposed to benefit cuts or deferrals.
The prospect of lower equity returns in years ahead threatens to weaken pension funds’ financial outlook. SSGA expects weak economic growth will weigh on equity returns, and projects that developed market equities will return just 6.1% over the next 10 years.
The UK-based consultancy Redington says the long-term equity risk premium is a risk-free rate plus about 3–3.75%, and over the near term probably lower. Investment returns comprised 64% of the revenue of US state pension plans between 1985 and 2014, the single largest source of funds, according to the National Association of State Retirement Administrators (NASRA). These state plans were targeting a 7.62% assumed annual return as of February 2016, NASRA says, which will be hard to achieve in the future. The median annualised public pension plan return in the ten years to December 2015 was just 5.8%, according to the San Francisco-based consultancy Callan Associates.
Meeting liabilities and funding targets is hard enough without volatile equity markets and negative yields and policy rates that render fixed-income returns inadequate. Factor investing can help on a number of fronts, and the ability of factor strategies to address the current conundrum is fueling adoption, according to leading providers.
Just as MRI scans give doctors a detailed view of what’s ailing a patient, factor analysis can help institutional investors to understand the true exposures in their portfolio – and what they can do to improve their financial health. Northern Trust Asset Management’s engineered equity team – the firm’s term for its smart beta capability – has performed factor assessments for about 60 institutional portfolios, says Michael Hunstad, head of quantitative research in the active equity group. For institutions unsure where to start with factor investing, says Hunstad, those reviews form an effective starting point: “They tend to show that clients have some factor exposure, whether they know it or not, because active managers are taking risks, whether known or not.”
While the factors selected will vary by client, pension funds are often interested in risk mitigation through low volatility strategies, Hunstad continues. Pension funds often have surplus volatility, particularly when they are de-risking and utilising LDI strategies. Every fund will have a different volatility profile, but as a rule of thumb, a pension fund with a 60–40 split between equities and bonds, targeting a 12 to 15-year duration on its fixed income portfolio, could have a 12% volatility level.
Although it is theoretically possible to reduce that to zero by fully defeasing the liability stream with fixed income instruments, Hunstad says its more common that clients want to reduce their equity volatility by about half.
When clients understand that they have exposures to source of return and volatility that were not clear before a factor analysis, “it’s an eye-opener,” says SSGA’s Heinel. Adopting a factor approach entails a series of four decisions, she says – what it replaces in the portfolio, how it will interact with other allocations, how it is benchmarked, and whether to utilise a single-factor or multi-factor approach.
Which factors and why?
Many investors are currently looking at adding value exposure since value has been out of favour for several years. State Street’s research shows that value, which targets the premium in low-valuation equities, has added a mean annualised excess return of 1.15% over the MSCI Developed Equities index since 1993.
In a similar response to prevailing conditions, the need to reach actuarial return targets without impairing portfolio value has made risk mitigation the second most popular objective for factor investing, says Shores. “Looking for returns in a way that is responsible with risk is a close second,” she says. “Minimum volatility strategies have become by far the most popular and fastest-growing part of the smart beta universe. That’s obviously a very attractive endeavour if you’re worried about the amount of equity risk but you can’t afford to reduce your equity allocation because you have to meet those actuarial requirements.”
So attractive are low-volatility strategies in fact that some market participants have raised concerns that investors are chasing performance by investing more into the expensive low-volatility factor, and could be adversely affected by a sharp reversal of the trend. SSGA says in a recent commentary that while low-volatility strategies have become expensive on a relative basis, valuation levels for low-volatility assets are “not at an extreme level and certainly not compared to historically high” levels reached in 1999 and 2009. Given the recent increase in equity volatility, “we would expect investors to pay a premium for low volatility assets that can provide a hedge against market downturns to history,” SSGA concludes.
The rising cost of investing in the low-volatility factor highlights the increasing importance of understanding how to time the use of factors. Factors tend to work best in certain market conditions, and can remain out of favour for long periods of time. State Street has developed models to forecast smart beta total returns by estimating the excess return of key factors based on current valuations and historical premiums, which are added to total return forecasts for underlying equity markets.
Factor investing for institutions is developing in various directions and the most sophisticated strategies are being designed without trying to make them fit an ETF wrapper. Late last year, BlackRock introduced a strategy aimed at taking factor-based investing to a new level. Its long-short style capture funds seek to capture the pure premium of the style factors and decouple them from the return of the broad market to produce an outcome that’s uncorrelated with a traditional stock and bond portfolio.
Assessing factor investing within a broader perspective is the next stage of development, says Phil Tindall, director of investments at Willis Towers Watson, which pioneered the practical implementation of smart beta by pension funds. “Factor investing moves into this spectrum between pure market-cap allocation and traditional alpha generation,” he says. From that vantage point, Factor investing gives clients “a portfolio of ideas”. Those ideas have a long runway ahead: “We’re still in the early stages of thinking about factor investing in this more sophisticated way.” How, and to what extent, ETFs will play a role in this development clearly remains to be seen.