Factor-Based Investing

Transcription

1 Aon Hewitt Retirement and Investment Factor-Based Investing Risk. Reinsurance. Human Resources.

2 Factor-Based Investing Summary The right equity portfolio for an investor depends on their risk and return objectives, investment beliefs, cost constraints and governance resource. Risk-adjusted returns are often considered when setting asset allocation, but can be overlooked when constructing an equity portfolio, as some equity investors follow market capitalisation strategies without considering any other approaches beforehand. There are a number of widely available alternative factor based indices using different stock weighting techniques (often known as Smart Beta strategies) which can be attractive in a number of different scenarios for investors who: want to reduce sensitivity to equity market movements through low-volatility investments; are seeking different sources of returns but may have governance or cost constraints or have an aversion to significant active risk; are looking to improve potential long-term risk-adjusted returns of an equity portfolio by investing in a combination of factors. Market cap doesn t always fit Market capitalisation based equity portfolios provide exposure to each company in weights equal to the value of the shares available to investors. For a number of reasons passive equity investments constructed in this way remain popular. They are easy for investors to understand and can provide liquid exposure to global equity markets at a relatively low cost. However, both active managers and supporters of factor investing question why investors should hold more of an asset just because it is large in size, or has performed well recently. Capturing a factor There are a number of different ways to construct equity indices which do not follow a market capitalisation weighting method, which have been designed to keep fairly constant exposure to a specific factor using a rules-based approach. These include approaches which weight stocks based on certain characteristics for instance company accounting ratios or stocks which have exhibited low volatility. In this paper we focus on two factors, value and low volatility and it is the exposure to a particular factor which drives performance from this type of investing. Selecting and combining appropriate factors can also provide the benefits of capturing the long-term risk premium for each factor, whilst dampening volatility over shorter periods. The right approach will depend on an investor s circumstances and we have helped a number of clients tailor their equity allocations based on their objectives. The following scenarios illustrate how factor investing can be used to achieve this. Aon Hewitt Factor-Based Investing 2

3 Scenario 1: Risk reduction An investor who requires the outperformance associated with equities, but with an objective to reduce equity portfolio volatility, could consider one of the low volatility approaches. The relative liquidity and low cost of a low volatility equity portfolio compared to some alternative asset classes can be attractive. This can be particularly important for pension schemes which have implemented a structured de-risking plan involving a gradual reduction in exposure to higher returning asset classes. The Minimum Variance method is a common approach to low volatility investing. Minimum Variance portfolios allocate to companies which are not necessarily low volatility stocks in isolation but, when combined in a portfolio, achieve an aggregate reduction in volatility. This is illustrated below, by comparing the volatility of the MSCI World Minimum Volatility index (a minimum variance approach) to the MSCI World index (a market capitalisation index) over 15 calendar years. Calendar year volatility MSCI Index: MSCI World Minimum Volatility-ND MSCI Index: MSCI World-ND 20 Annual Volatility (%) The graph below also demonstrates how a minimum variance approach has the potential to protect during equity market downturns over the same period. The fall in value ( drawdown ) associated with the minimum variance approach is lower than a comparable market capitalisation index. Cumulative drawdown MSCI World Min Volatility MSCI World 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% -30.0% -35.0% -40.0% -45.0% Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 1 As at 31 December 2015 Aon Hewitt Factor-Based Investing 3

4 Scenario 2: Accessing Risk Premia 1 We firmly believe that selecting high quality unconstrained active managers can add value and allow investors to access discrete risk premia. However, we recognise that this isn t suitable for all. There are rules-based approaches which enable investors to target different sources of returns within their equity portfolio which they may not otherwise be able to access. Some rules-based factor indices allow investors to access their preferred style of equity management in a low governance and low cost way. Management fees in many cases have become more in line with passive market capitalisation investing. One approach is targeting the value risk premium. The persistence of the value risk premium has strong academic support, although the price of capturing the benefit of the factor is patience and often the willingness to be contrarian. For rules-based strategies which are aimed at capturing the value risk premium or factor, the periodic rebalancing of the index constituents introduces a systematic approach to selling when the assets are no longer cheap not so different to the process an active manager might implement. Rolling 5 year returns of MSCI world growth minus MSCI world value to December 2015 MSCI World Growth Outperforms MSCI World Value Outperforms 10% 5% 0% -5% -10% -20% Dec 79 Jan 82 Jan 84 Jan 86 Jan 90 Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Source: Aon Hewitt, evestment. Date: 31 December 2015 Data: GBP, Total Return Net Index Performance Fundamental based approaches may generate better risk adjusted returns than market capitalisation indices in most cases BUT this may not occur for long periods. 1 an asset s risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset Aon Hewitt Factor-Based Investing 4

5 Scenario 3: Better risk-adjusted returns Risk-adjusted returns are often considered when setting asset allocation, but can be overlooked when constructing an equity portfolio particularly for passively managed mandates. For investors who recognise some of the limitations associated with the market capitalisation approach, investing in combinations of factor-based strategies has delivered higher risk adjusted returns, at least over the longer term. Some investors select an index fund under the impression that this will always provide diversification at low cost, without understanding possible risks, especially in small markets,such as extreme concentration in a small number of stocks or to a particular industry. The market capitalisation approach invests a larger proportion of the index to stocks which have been driven up to levels which may not reflect their intrinsic value. Although investors will benefit from the price increase, these are potentially the holdings which may suffer the greatest losses when market bubbles burst. One well-known historic example of this is the Dotcom Bubble when equity market indices developed a relatively high concentration to Technology, Media and Telecommunications sectors. Weight of the IT sector in the S&P 500 index 50% Weight of the IT sector in the S&P 500 Index 40% Index weight 30% 20% 10% 0% Source: Datastream Combining strategies can be a particularly effective way of including rules-based factor indices in a portfolio. The chart below demonstrates how a higher Sharpe Ratio, a common measure of risk-adjusted returns, might be achieved by combining exposure to different factors compared to an investment in a market capitalisation index. The portfolio below combines a minimum variance low volatility approach and a value weighted index constructed using a composite of company fundamentals in equal proportions. Aon Hewitt Factor-Based Investing 5

6 Index risk return 10.0% 9.0% 8.0% Annualised Return 7.0% 6.0% 5.0% 4.0% Low Volatilty 50% Low Volatility / 50% Value Weighted Fundamental MSCI World Value Weighted Fundamentals 3.0% 2.0% 1.0% 0.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0% Source: Aon Hewitt, evestment. MSCI, S&P, FTSE Data: GBP, Total Return Net Index Performance. 10 years to 31 December Annualised Risk 50% Low Volatility / 50% Value Weighted MSCI World Fundamentals Return (% pa) Risk (% pa) It should be noted that the above combination is a backtest and not a live portfolio implemented over the entire period shown. We would not typically expect the observed level of outperformance relative to a market capitalisation index over all time periods. Sharpe Ratio Aon Hewitt Factor-Based Investing 6

7 Conclusion Implementing an equity allocation is an active decision and market capitalisation indices may not always be the best fit. The scenarios above demonstrate how equity portfolios tailored towards specific factors have the potential to be better suited to investors objectives. Although factor-based investments can produce periods of underperformance against market capitalisation indices over the short to medium term, over the longer term, investing in combinations of factors has the potential to deliver higher risk adjusted returns. We recommend talking to your usual Aon Hewitt contact to discuss how factor-based investing can be employed effectively within your strategy. Glossary MSCI minimum volatility index Minimum variance approach which weights portfolios to target the lowest portfolio volatility for a given opportunity set and under certain constraints. Drawdown Measures the fall in cumulative return from a previously reached peak in market value. Value stocks Stocks which are priced cheaper than their company fundamentals (earnings, sales etc.) would suggest. Sharpe ratio Risk adjusted return measure, defined as the excess return above a risk free return, per unit of volatility. Value weighted fundamental indices Illustrative portfolio in Scenario 3 uses a fundamental based index which weights portfolios using a combination of fundamental factors, including total cash dividends, free cash flow, total sales and book equity value. Contact Oliver Sample Associate Consultant +44 (0) oliver.sample@aonhewitt.com About Aon Hewitt Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is a global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit: aonhewitt.com Follow Aon on Twitter: twitter.com/aon_plc Sign up for News Alerts: Aon Hewitt Factor-Based Investing 7

8 About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance brokerage and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 72,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions. For further information on our capabilities and to learn how we empower results for clients, please visit: This document and any enclosures or attachments are prepared on the understanding that it is solely for the benefit of the addressee(s). Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated to anyone else and, in providing this document, we do not accept or assume any responsibility for any other purpose or to anyone other than the addressee(s) of this document. Notwithstanding the level of skill and care used in conducting due diligence into any organisation that is the subject of a rating in this document, it is not always possible to detect the negligence, fraud, or other misconduct of the organisation being assessed or any weaknesses in that organisation s systems and controls or operations. This document and any due diligence conducted is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties (including those that are the subject of due diligence) and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by third parties (including those that are the subject of due diligence). This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinions or assumptions in this document have been derived by us through a blend of economic theory, historical analysis and/or other sources. Any opinion or assumption may contain elements of subjective judgement and are not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance. Views are derived from our research process and it should be noted in particular that we can not research legal, regulatory, administrative or accounting procedures and accordingly make no warranty and accept no responsibility for consequences arising from relying on this document in this regard. Calculations may be derived from our proprietary models in use at that time. Models may be based on historical analysis of data and other methodologies and we may have incorporated their subjective judgement to complement such data as is available. It should be noted that models may change over time and they should not be relied upon to capture future uncertainty or events. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: Registered Office: The Aon Centre The Leadenhall Building 122 Leadenhall Street London EC3V 4AN Copyright 2016 Aon plc aon.com Risk. Reinsurance. Human Resources.