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‘Factor investing’ earns a place on the menu

‘Factor investing’ earns a place on the menu

SINCE its genesis the cooks of the investment industry have relied on the same basic ingredients when concocting a diversified portfolio to please their palate and keep their returns healthy.

The chefs — or asset allocators in the industry parlance — divvy up money between the major asset classes such as bonds and stocks, and stow the balance in ‘alternative’ investments such as real estate, commodities and hedge funds.

The exact breakdown can vary greatly, but asset classes are the building blocks of investment portfolios.

But increasingly, the biggest institutional investors are leaning towards a revolutionary method of parcelling up and allocating their money. So-called ‘factor investing’ has jumped from the more recondite niches of the asset management sector and gone mainstream.

“This is the new frontier,” says Andrew Ang, head of factor investing strategies at BlackRock and an academic in the field. “We have come to the stage where we’ve transcended asset classes and moved on to factors.”

Rather than crude and sometimes arbitrary allocations to asset classes, factor investing involves breaking down securities into their fundamental drivers and using those to create a more precise, balanced portfolio — at least in theory. For example, corporate bonds are influenced by both interest rate movements and creditworthiness, and the factors can move in opposite directions.

To stretch the cooking metaphor, if fixed income and equities are a traditional meal, factor investing examines the basic ingredients and reconstitutes the dishes to ensure that a diner eats all the vitamins in the right doses.

Factors have been known about for some time — especially popular equity factors like ‘value’ and ‘growth’. But the first institutional investor to embrace publicly a fully factor-based approach was PKA, a $35bn Danish pension fund. In 2012 PKA restructured its entire equities portfolio to invest in popular ‘risk premia’ rather than old-fashioned, blunter allocations such as European and global equities.

PKA has since been mimicked by many other institutional investors, according to Siddhartha Sinha, a director at Deutsche Bank’s equities structuring group. “It’s a nascent phenomenon, but it is gathering pace,” says Mr Sinha. “In the financial crisis we found out that many traditional asset classes are actually correlated, so that has led to a lot of examination of the underlying factors, so you can manage risks.”

Not all investors are convinced this approach is best. Over 40pc of investors with total assets of $1.2tn surveyed by State Street Global Advisors — a provider of index investment solutions — indicated that traditional asset allocation was still their most important method, largely because of its simplicity. But the trend is clear. As many as 65pc of respondents said they also classified their overall portfolio according to factors, and 30pc said this was now their most important method.

Investors can now also access individual factors cheaply through passive, systematic strategies like exchange traded funds. In fact, its rise is related to the emergence of ‘smart beta’ ETFs that often tilt towards one or several factors. There is about $282bn in smart beta ETFs, and BlackRock — the largest ETF provider — says the sector will cross the $1tn mark by 2020, and $2.4tn by 2025.

BlackRock’s Mr Ang argues that for something to be a formal factor it has to have an underlying economic rationale; the turnover has to be high; the historical data has to be exhaustive enough to test assumptions rigorously; it must offer some diversification from other factors; and it has to be scalable.

So if most traditional asset classes look overvalued, can a more granular, factor-based approach reveal some hidden pockets of value?

Sadly not. According to SSGA, popular factor strategies such as ‘low-volatility’ — where investors buy steadier, more boring stocks — are exceedingly expensive, while even ‘quality’, or stocks of companies with strong balance sheets, is far less expensive than it was.

“We were hoping that something would look cheap, but nothing does,” says Lori Heinel, chief portfolio strategist at SSGA.

Published in Dawn, Business & Finance weekly, June 20th, 2016

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