FACTOR INVESTING FROM ALM PERSPECTIVE. VBA ALM conference: 2 nd of November, 2017, Amsterdam Jiajia Cui, Shell Asset Management Company

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1 FACTOR INVESTING FROM ALM PERSPECTIVE VBA ALM conference: 2 nd of November, 2017, Amsterdam Jiajia Cui, Shell Asset Management Company 1

2 FACTORS AS BUILDING BLOCKS OF ASSETS & LIABILITIES A few factors act as the underlying common return and risk drivers of major asset classes and liabilities. Fundamental factors: Market, interest rate, credit, inflation and illiquidity; Style factors: Size, Value, Momentum, Low Risk, Quality, Trend Expected Asset Premium Factor premiums as building block for asset risk premiums Equity MinVol EQ Private Equity Real estate Hedge funds High Yields EM Debts IG credits DM gov. ILB Market InterestRate Credit Illiquidity Size Value Momentum LowRisk Inflation Others

3 WHY INTEGRATE FACTOR APPROACH WITH ALM? Key questions from Board of Trustees perspective are: 1) What factors drive the risk and return of the fund? 2) What exposures should the fund be exposed to? 3

4 SAA AND FACTOR RISK ALLOCATION The purpose of asset allocation is to create desirable exposures to the underlying factors. Top-line concerns of pension fund managers: What drives the risk and return of the fund? Do we get appropriate returns for the risks we take? Do we have diversified or concentrated risk taking? 9 Illustration: Strategic allocation of Total Dutch pension funds was dominated by equity factor. (Data: DNB, Tabel 8.9 Belegd vermogen voor risico pensioenfondsen, 2007K4. NOT Shell pension funds.) Asset-class diversification (left) -- does not naturally lead to-- Factor risk diversification (right) HY RE 11% Comm PE 3% HF 3% IG 1 ILB Mortg Gov 18% EQ (DM) 34% EQ (EM) 1 9% 8% 7% 6% 4% 9 market 3% 1% -1% Volatility Interest rate Market Return Credit other premiums 9 of the volatility of the portfolio is due to equity market factor alone, which also explains why the portfolio tanked in 2008; 9% due to credit factor and due to other factors (e.g. illiquidity, inflation, value, size); Interest rate factor is the only diversifier which reduces the portfolio risk by -4%; 4

5 BALANCE SHEET AND FACTOR RISK ALLOCATION Assets / liabilities Funding ratio Funding ratio risk and return RE 11% HY IG 1 Comm PE 3% HF 3% ILB Mortg Gov 18% EQ (DM) 34% EQ (EM) Cash flow pension liabilities % 6% 4% - inflation Other premium Credit Market Interest Rate (Data: DNB, Tabel 8.9 Belegd vermogen voor risico pensioenfondsen, 2007K4. NOT Shell pension funds.) -4% Volatility Return Key question #1: What drives the risk and return of the fund? The (equity) market exposure contributed to funding ratio returns in the long term. Interest rate exposure (from unhedged liabilities) dragged down the growth in the funding ratio 5

6 USE FACTORS TO COMPLEMENT ALM/SAA STUDIES ALM process makes key trade-offs among long term financing objectives v.s. long term risk tolerance of pension funds. Factor Factor approach provides another lense through which to look at the portfolio to enhance our understanding of portfolio and funding ratio dynamics. Reward A B C Funding Ratio Risk and Return Strategy C Strategy B 1 Risk 1 8% 6% Risk: e.g. funding ratio volatility, severity of underfunding, remedy contribution, etc Reward: e.g. funding ratio return, indexation 4% - quality, contribution reduction, etc -4% Volatility Return Volatility Return Interest Rate Market Credit Other premium inflation 6

7 FACTOR INVESTING AND ASSET ALLOCATION Key question #2: what exposures should the fund be exposed to? Strategic exposures to risk premia pay off over the long run; A few common factors play the essential role here; A few style factors (e.g. value, size, quality, etc) are identified to be able to provide additional sources of return and diversification in nearly every asset classes. Dynamic factor asset allocation could add value, as Factors may exhibit extreme valuation from time to time, and Factor performance varies over macro regimes (incl. business cycles, liquidity cycles, etc). 7

8 FACTOR PREMIA OVER BUSINESS CYCLE: Implications for factor diversification at top level Implications for dynamic factor allocation and hedging at top level 4 Market (EQ) 1 Interest Rate Expansion Slow down Contraction Recovery - Expansion Slow down Contraction Recovery 1 1 Credit 4 Low Risk (EQ) Expansion Slow down Contraction Recovery -2 Expansion Slow down Contraction Recovery Figure: Annualized average factor return in each business cycle ( ). Note: Business cycle here is indicated by Conference Board leading indicator. Other BC indicators (e.g. OECD leading indicator, ISM, etc) give largely similar patterns. 8

9 FACTOR PREMIA OVER LIQUIDITY CYCLE: Implications for factor diversification at asset specific level Implications for dynamic factor allocation at asset specific level 2 Market (EQ) 4 Low Risk (EQ) more tightening less tightening more lossen less lossen -2 more tightening less tightening more lossen less lossen 6% Credit 3 Size (EQ) 4% % -1-6% more tightening less tightening more lossen less lossen -2 more tightening less tightening more lossen less lossen Figure: Annualized average factor return in each liquidity cycle ( ). Note: Liquidity cycle here is indicated by bank lending survey. 9

10 SUMMARY 1: FACTORS FROM ALM PERSPECTIVE ALM process makes strategic trade-offs among long term financing objectives v.s. long term risk tolerance of pension funds. Factor approach provides another set of lenses through which to look at the portfolio to enhance our understanding of portfolio or funding ratio dynamics. Both are necessary to answer the key questions from trustees perspective: 1) what key common factors drive the risk and return of the fund? 2) what exposures the fund should be exposed to? 10

11 SUMMARY 2: INTEGRATE ALM/SAA WITH FACTORS 1. Use factors to understand the underlying common drivers of assets and liabilities 2. Use factors to complement ALM studies Building assumptions and scenario discussions 3. Use Factor investing for return enhancement and risk reduction Create allocation to the desirable factors Dynamically adjust asset/factor exposures 11