“Any investment institution with a long investment horizon that wants to change its investment model needs to show very clear justification,” said Alfred Slager, professor of pension fund management at TiasNimbas Business School at Tilburg University in the Netherlands, addressing a Robeco factor investing seminar in Rotterdam in January.
Factor investing and smart beta, by taking into account risks that stretch across different asset classes – from economic growth and political uncertainty to credit, duration, size, value, the low-volatility anomaly and illiquidity – should not prove too problematic on that score.
Slager’s presentation was preceded by a contribution from Professor Andrew Ang of the Columbia Business School, a leading thinker in this field and co-author of an influential 2009 report that showed just how thoroughly factor exposures explained the returns of Norway’s (actively-managed) Government Pension Fund Global.
“Asset owners were being ripped-off by active managers and didn’t understand the underlying economics of the assets they were investing in,” said Ang. “But now, after the factor revolution, we can look through to the underlying beta in asset classes and asset strategies, diversify much more cheaply and effectively and create proper benchmarks for active managers.”
And yet, he conceded: “Sadly, many investors have stuck with the status quo and haven’t realised the benefits of the factor revolution.”
Indeed, even the Norwegian fund chose not to go all-out with factor investing, apparently for reasons of complexity. Norges Bank warned against “introducing systematic risk factors to the reference portfolios that weaken transparency and testability”. The challenges associated with asset classes being bundles of different risk factors “can be addressed adequately within an asset based framework”, albeit with enhanced portfolio performance analytics that “embrace multiple risk factors”, it maintained.
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 into risk exposures that come from adopting a factor-based framework: the Norwegian position, essentially. The second identifies factor tilts and corrects them as far as possible using mostly traditional asset classes and strategies: the many investors that have awarded fundamental indexing or low-volatility mandates might be categorised in this way. The third approach aims to create a portfolio that is fully factor-optimised, using long/short, approaches: Denmark’s PKA is on the way to something like this.
But Slager’s survey of the latest pension fund annual reports revealed almost no mention of factors or factor investing, suggesting that even those investors that are pursuing these ideas still struggle to communicate them to members.
“There is a lot of interest in these processes but also a lot of uncertainty about how to embed them into the portfolio”
“Today, pensions funds that have taken any steps at all have usually taken steps one and two, and dream about step three,” Slager reflected. “There is a lot of interest in these processes but also a lot of uncertainty about how to embed them into the portfolio. If factor investing is so compelling, how come every pension fund isn’t doing it?”
One barrier to a full adoption of the factor-investing and smart-beta concepts was identified by Ang: just as the index-fund revolution was led from outside the traditional asset management field by the likes of John Bogle’s Vanguard, today smart beta is largely a boutique pursuit. That makes manager selection fraught with risk.
But long before managers are mandated, Slager said that the concepts themselves introduce “a level of abstraction” that is a “considerable challenge” given today’s emphasis on transparency and communication. This is a problem because investors need to establish beliefs about whether or not 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 are very sensitive to real-world constraints on transacting or short selling.
Factor investing: an investors’ checklist
• 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 your chosen factors.
• Be consistent in implementation.
• Recognise that these are active choices that require an active stance.
• Decide early on how static or dynamic your allocations to factors will be.
“These risk premia do not come for free,” as Ang warned. “They are going to fail from time to time, which is why we get paid to hold them. We need to understand when they will fail if we are going to be able to determine whether it is appropriate for us to hold them in our institutions. Am I a value investor? Can I buy things against the grain while everyone else is piling into growth stocks? If not, perhaps that’s not for me.”
Pension funds need to think, not only in terms of risk as well as simply return, but in terms of balance-sheet risk, specifically, Slager added.
“The question is not whether you have generated a few basis points of additional return, but whether the new structure is helping you to achieve more stable coverage ratios with less downside risk,” he explained.
This is essentially a benchmarking question, the importance of which was evident on the fringe of the seminar, where a number of pension fund representatives reported unease from trustees that had seen their low-volatility mandates drastically underperform equity markets in their first year of track record – just as they ought to have done.
Finally, as both Slager and Ang pointed out, even once these investment beliefs are agreed and communicated to members, they introduce 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.
With all of this in mind, Slager and his colleagues presented an eight-point checklist for institutions considering the plunge into smart beta or factor investing (see box), in the hope that this might make it easier to overcome the hurdles between them and a beneficial change in strategy.
“Many institutions go through this debate today, and it’s the most important question we can ask – a question of governance,” as Ang put it. “Just as most investors didn’t embrace the first factor revolution, not all investors are going to take advantage of the current revolution –
but the few that do embrace it are going to be better off.”