AN INTRODUCTION TO FACTOR INVESTING

Transcription

1 WHITE PAPER AN INTRODUCTION TO FACTOR INVESTING THIS DOCUMENT IS INTENDED FOR INSTITUTIONAL INVESTORS ONLY. IT SHOULD NOT BE DISTRIBUTED TO, OR USED BY, INDIVIDUAL INVESTORS.

2 OUR RESEARCH COMMITMENT As your trusted investment partner, we are committed to delivering innovative, robust strategies that help you achieve your investment goals. We place the highest value on original research, using intellectual rigour to question traditional paradigms. And, because transparency is a key part of our partnerships with clients, we commit to sharing these insights with you. This white paper, An Introduction to Factor Investing, is written and presented by ILIM s Indexation and Quantitative Strategies teams. Highly qualified and experienced, the team has applied the academic scrutiny you would expect from Ireland s leading asset manager. EXECUTIVE SUMMARY Factor investing has begun to edge into the mainstream, due to its ability to generate superior riskadjusted returns than market capitalisation weighted indices. Empirical studies have demonstrated this. Factor investing is a way of constructing equity portfolios where exposures are driven not by traditional market cap weights, but by underlying factor characteristics. Factor performance is cyclical. For investors seeking to generate a smoother return profile over time, there is strong evidence to support the claim that there is benefit to investing in more than one factor at a time. The combination of individual factors into a blended multi-factor fund delivers a higher information ratio (excess return divided by tracking error) than any of the individual factors. Research shows that the greatest loss of capital (known as the maximum drawdown) in a composite, multi-factor fund is vastly lower than the loss of capital of any of the individual factor funds; a direct result of the de-correlation of factors. A key challenge for investors considering this type of investment is that a one-size-fits-all approach is not appropriate. The appropriateness of factor investing, and indeed the type of strategy adopted, will depend on the ultimate outcome desired by investors.

3 INTRODUCTION At ILIM, we have been pioneering and refining factor investing for over 20 years. We are among the first firms ever to take factor investing out of the theoretical world and apply those theories in the real world. Traditionally, portfolio returns were attributed to broad market exposure with excess returns seen as a result of active portfolio management. But increasingly, a number of return components previously attributed to active management, are now being recognised conventionally as systematic. This has given rise to a number of new strategies aiming to capture this return component in a systematic, transparent and cost effective manner typically through quantitative approaches by allocating to underlying factors. A factor is essentially any characteristic of a group of securities that is determined to be a key driver of the risk and return profile. Factor investing is a way of constructing equity portfolios where exposures are driven not by traditional market cap weights, but by underlying characteristics of the security. The area of factor investing has grown in popularity in the last few years. Some investors have already actively incorporated factor strategies within their portfolios, while many more are still considering the role these strategies could play in their portfolio, and how best to implement them. A key challenge for investors considering this type of investment is that a one-size-fits-all approach is not appropriate. The appropriateness of factor investing, and indeed the type of strategy adopted, will depend on the ultimate outcome desired by investors. A factor is essentially any characteristic of a group of securities that is determined to be a key driver of the risk and return profile An Introduction to Factor Investing 1

4 FACTOR INVESTING IN CONTEXT Traditionally, equity investing has been divided along the battle lines of active and passive management. Passive managers have delivered returns in line with marketcapitalised benchmarks, while active managers have sought to outperform them. Recently, however, factor investing has inched from the fringes of the investment world towards the mainstream. Factor investing is not a new concept. It has its roots in academic research, with several classic papers highlighting how particular factors have driven asset returns. The roots of factor investing can be traced to the Capital Asset Pricing Model (CAPM) (Sharp, 1964). The idea underpinning the CAPM was developed in the 1960s. In the CAPM, one factor, the market, explains stock returns. This exposure is captured by beta. Beta is a measure of the sensitivity of a stock s return to the return on the market. The remaining part of a stock s return is attributable to stock specific characteristics. In the mid 1970s, further research suggested that other stock characteristics were also responsible for explaining a stock s return. The work of Ross (1976) introduced Arbitrage Pricing Theory (APT) which proposed that the expected return of an asset was a function of a number of factors as opposed to a single market factor. In the early 1990s, Fama and French (1993) introduced a threefactor model which added size and value factors to the market factor. A year later, Titman & Jagadeesh uncovered that an equity's performance yesterday can tell us a lot about its performance tomorrow. This marked the birth of the momentum factor. However, it wasn t until 1997 that Carhart (1997) added momentum as a fourth factor. To date, many investors, specifically active managers, have been using these insights into underlying factors to build portfolios and capture excess returns over the market. This practice is now being widely discussed following the publication of a research report in 2009 analysing the performance of the Norwegian sovereign wealth fund by Ang, Goetzmann and Schaefer. It concluded that the value generated by the fund s active management was not due to alpha generation, but rather to factor exposure. Exhibit 1: Development of sources of portfolio returns Alpha + Factors Alpha Alpha + Factors + Market Factor Returns Market Returns Market Returns Prior to After 2010 Source: ILIM 2 An Introduction to Factor Investing

5 The rise of factor investing has introduced a third tier to the traditional investing model as it blends elements of both passive and active management. Factor investing is similar to active investing in that it aims to outperform a marketcapitalization weighted index. However, unlike the traditional model, where active and passive strategies were at either ends of the spectrum in terms of both costs and transparency, factor investing enables both passive and active strategies to offer solutions. Both offer exposure to factors in a lower-cost, rules-based and transparent manner. Exhibit 2: Factor investing in context Diversified exposures to broad asset classes Passive investing Accepts market return Benchmark defines strategy Potential for outperformance Factor-based investing Leverages public information to estimate expected return Targets exposures to specific firm characteristics Fundamental active investing Attempts to find opportunities to outperform the market Potential for higher costs Source: ILIM "Factor investing enables both passive and active strategies to offer solutions" An Introduction to Factor Investing 3

6 TYPES OF FACTORS A factor is a variable that drives stock returns. To be credible, a factor should have a solid theoretical grounding and be persistent over time. At last count there are 300+ documented factors in academic literature. A large number of factors/styles have subsequently been discovered. The vast majority fall under the following headings: Exhibit 3: Factor definitions and rationales VALUE QUALITY MOMENTUM Definition Stocks that are trading at low prices relative to their fundamental value (price to equity, price to book). Rationale Over the long term, stocks that offer good value have historically delivered a higher return than those that appear expensive. Definition Stocks that are characterised by low debt, stable earnings growth and other 'quality' metrics delivering sustainable returns to investors (low debt, ROE, profitability, accruals). Rationale High-quality stocks have delivered better risk-adjusted returns than those that score poorly on quality metrics. Definition Stocks that exhibit recent strong positive (negative) performance (6 12 month trailing average). Rationale Stock markets exhibit positive momentum with persistent trends. Markets aren t always efficient: if a stock went up in price yesterday, it has a slightly better than chance of going up again tomorrow. The momentum factor identifies those stocks with strong directional trends. SIZE VOLATILITY YIELD Definition Stocks with small market capitalisation (large cap, small cap). Rationale Small-cap stocks have tended to deliver a higher return than largecaps to compensate for their higher sensitivity to the economic cycle. Definition Stocks with low historical expected volatility of returns. Rationale There is evidence that identifying a low volatility basket of stocks will have much lower volatility than a market-cap-based fund, but that the give-up in return is not as significant. Definition A stock s income return, paid in the form of dividends. Rationale Stocks with higher than average dividend yields have historically delivered higher total returns. Source: ILIM 4 An Introduction to Factor Investing

7 HISTORIC FACTOR PERFORMANCE Individual factors can be seen to deliver superior risk-adjusted returns over the longer term. The graph below illustrates the performance of different factor exposures versus the market- capitalisation-weighted benchmark from 1990 to It shows that individual factors can either outperform the benchmark from a return perspective and/or deliver lower-risk characteristics than a market-capitalisation-weighted benchmark. Exhibit 4: Factor performance characteristics Annualised return 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% Annualised volatility Minimum volatility Quality Dividend yield Composite Momentum Global Portfolio Size (equal weighted) Value Source: ILIM An Introduction to Factor Investing 5

8 Investing in individual factors has been shown to deliver an excess return over the long term, and could be appropriate for investors seeking to target certain risk premia. But, it is important to note that factor performance is cyclical. For investors seeking to generate a smoother return profile over time, there is strong evidence to support the claim that there is benefit to investing in more than one factor at a time. At different points in the cycle, different factors tend to perform: when one factor is lagging others will tend to be performing well, so it pays to invest in a broad set of factors. A stark example is the contrasting characteristics of the momentum and value factors. In periods of high growth, such as the late 1990s, value stocks fell out of favour, but these are the very periods when momentum stocks are desirable, as they benefit from a strong positive trend. When the trend reverses, and momentum stocks decline, this typically coincides with a return to favour of value stocks. We saw this in early Exhibit 5: Cumulative factor performance % A subtler argument for blending disparate factors comes from the different information sets that each uses. Some styles, such as Quality, use only accounting information and change at the rate of the company s financial-reporting cycle. In North America, this is typically quarterly; while in Europe, annual or semi-annual reporting is more common. Sentiment/Momentum factors, on the other hand, are based on price movements and analysts revisions. They are independent of accounting cycles and move in line with the market as prices change or estimates are revised. It s easy to see that the latter group of factors is much more transient in nature. This combination of long-term factors, with more transient factors, improves time diversification and allows us to exploit the term structure of opportunities available. 120% 80% 40% 0% -40% Value Volatility Equal Weighted High Dividend Yield Quality Composite Momentum Source: ILIM In further support of a multi-factor approach, the graph above shows the performance of individual factors and the performance of an equally weighted composite. This is a simple weighting scheme, but even so, it points to a smoother return profile than the individual factor strategies. Crucially, it still captures the enhanced risk-and-return benefits associated with the individual factor strategies. 6 An Introduction to Factor Investing

9 Exhibit 6, below, shows the correlations across a number of factors. The low, and in some cases negative, numbers demonstrate the benefit of investing in more than one factor. This can give rise to a significant reduction in drawdown experience for an investor who chooses to diversify their allocation across more than one factor, as represented by the "composite". The drawdown experience is our definition of peak-to-trough losses. Exhibit 6: Factor correlations The charts below (exhibits 7 and 8) show how a composite of factors improves outcomes (in terms of both return and risk) upon each individual factor. The combination of individual factors into a blended multi-factor fund delivers a higher information ratio (excess return divided by tracking error) than any of the individual factors. Furthermore, the greatest loss of capital (known as maximum drawdown) of the composite is vastly lower than the loss of capital of any of the individual factor funds; a direct result of the de-correlation of factors. Value Dividend Quality Momentum Liquidity Value 100% 25% 3% -35% -13% Dividend 25% 100% 12% -30% -30% Quality 3% 12% 100% 2% 11% Momentum 35% 30% 2% 100% 45% Liquidity -13% -30% 11% 45% 100% Exhibit 7: Factors' information ratio Value Dividend yield Minimum volatility Quality Momentum Size (equal weighted) Composite Exhibit 8: Factor drawdown relative to benchmark % % -10% -15% -20% -25% Value Volatility Equal Weighted Source for all charts: ILIM High Dividend Yield Quality Composite Momentum An Introduction to Factor Investing 7

10 HOW DOES FACTOR INVESTING RELATE TO CLIENT OUTCOMES? Having identified the growing trend for factor investing, and the supporting empirical evidence to justify the continued growth of factor investing, it is important to discuss how factor investing can help investors achieve their objectives. We have identified a number of potential ways factor investing can add value within a client s portfolio. We have summarised these below, together with a brief explanation of some of the key decision points we recommend that investors consider. Exhibit 9: Integrating factors into client portfolios Replace and complement active manager strategies Get more out of beta Risk reduction Completion funds A transparent, well diversified and low cost substitute for low-risk active strategies Improve the expected risk-adjusted return while retaining transparency and efficiency of Beta Introduce explicit downside risk protection or diversify unwanted risks Complement the factor exposures of the existing manager line up and implement tactical views along factor dimensions Higher expected returns after costs Higher expected returns Risk management Reduce unwanted risks and seek incremental returns Source: ILIM WHAT OPTIONS ARE AVAILABLE? For investors seeking to explore factor investing, there are two main options available in the market. Both are generally available on an indexed basis or an active basis. A choice of single factor strategies Value, High Dividend, Low Volatility, Quality, Momentum, Size. These are available on a stand-alone or blended basis Multi-factor strategies individual factor exposures are combined to form optimised strategies that deliver efficient exposures to multiple factors 8 An Introduction to Factor Investing

11 REPLACING ACTIVE FUND MANAGERS' STRATEGIES While active management certainly has a potentially valuable role to play in portfolios, there are many reasons why investors may look to replace active managers. These reasons could include cost pressures and consistency of returns. By enabling a targeted exposure to factor exposures, it may be possible to capture the majority of the active return by replicating exposure at a lower cost using factor investing. In such circumstances, a targeted factor strategy may be most appropriate. Although, as with the original active strategy, it is also important to be able to take a longerterm perspective to withstand the cyclicality of single-factor exposures. GET MORE OUT OF BETA For investors who have passive exposure to market-capitalisation-weighted benchmarks, it may be possible to enhance a portfolio s return profile by incorporating factor strategies that aim to outperform the market. In such circumstances, multi-factor strategies may be the most useful. They provide the objective of enhanced returns with the diversification of factor exposures to deliver a smoother return profile over time. REDUCE RISK Factor investing can also be useful for investors seeking to manage and control risk within their equity and multiasset portfolios. Investors could enhance their portfolio s downside protection and risk profile by incorporating factor strategies that aim to manage this downside risk. In such circumstances, multi-factor strategies might be the most appropriate. They provide the objective of better downside protection than the original benchmark, with the diversification of factor exposures to deliver a smoother return profile over time. COMPLETION PORTFOLIOS Within many multi-manager portfolios and fund-of-funds, a key issue could arise in terms of portfolio transparency. The underlying portfolio of assets could experience significant exposure tilts away from benchmarks resulting from the changing underlying exposures adopted by the independent managers. Such movements could expose the fund to unintended risks, for example factor exposures. Targeted factor strategies used on a stand-alone basis are useful here. The respective weights are specifically chosen (and regularly rebalanced) to balance these unintended exposures and manage risk within the portfolio. In such circumstances, single- factor strategies that can be blended together might be the most appropriate. TO FIND OUT MORE To discuss the findings in this paper, including the practical applications of factor investing, please speak to your Relationship Manager. An Introduction to Factor Investing 9

12 REFERENCES 1. SHARP, W F., Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, The Journal of Finance, Vol. 19, No. 3 pp ROSS, S 1976, "The arbitrage theory of capital asset pricing". Journal of Economic Theory. 13 (3): FAMA, E. F.; French, K. R. (1993). "Common risk factors in the returns on stocks and bonds". Journal of Financial Economics. 33: JEGADEESH, N., TITMAN, S., 1993, Returns to buying winners and selling losers: Implications for stock market efficiency, Journal of Finance 48, CARHART, M. M., (1997). "On Persistence in Mutual Fund Performance". The Journal of Finance. 52: ANG, A., BRANDT M.W., DENISON F., 2014, Review of the Active Management of the Norwegian Government Pension Fund Global. Available at: [Accessed 25 October 2016] 10 An Introduction to Factor Investing

13 ABOUT US Irish Life Investment Managers (ILIM) is a global investment management firm, managing assets across a broad range of asset classes with a reputation for investment innovation and customer-led product development. With a leading domestic market presence and strong international client base we deliver solutions to pension-fund trustees, investment advisers, insurance companies, corporations, charitable foundations and sovereign funds across the UK, Europe and North America. Our ability to deliver innovative investment solutions has driven our success to date. We have proven strengths in designing and delivering solutions that enable clients to achieve their desired outcomes. An Introduction to Factor Investing 11

14 AUTHORS The lead authors of this paper are profiled below: Anthony MacGuinness, CFA, CAIA Head of Quantitative Strategies Group As a member of the Executive Management Team and the Fund Management Executive, Anthony is responsible for leading the Quantitative Strategies Group. This team is responsible for the research and development of ILIM s quantitative investment strategies and portfolio solutions for the institutional and retail markets domestically and internationally. Anthony and his team have been responsible for the development of ILIM s range of multi-factor active equity funds. More recently, they developed risk management strategies including the Dynamic Share to Cash and Low Volatility Strategies. Prior to joining ILIM, Anthony worked in quantitative research roles for Irish National Treasury Management Agency (NTMA) and Pioneer Investment Managers. He holds a primary degree in Economics from Trinity College Dublin and holds both the Chartered Financial Analyst (CFA) and Chartered Alternative Investment Analyst (CAIA) designations. Paul Murray, BSc, MSc Quantitative Research Analyst Paul is a member of the research team within the Quant Strategies Group. The team is responsible for the ongoing research into factors that underpin the delivery of our multi-factor quantitative process. In addition, the team is responsible for the ongoing development of solutions that support ILIM s reputation for client-led solution development and investment innovation. Prior to joining ILIM, Paul worked for Callisto Asset Management, a systematic equity market neutral fund, where he was a Senior Research Analyst and Portfolio Manager responsible for the development and oversight of the investment strategies. He also held a quantitative research position at Fidelity International where he was involved in the development of global equity strategies. Paul has an MSc in Quantitative Finance from University College Dublin, a BSc in Financial & Actuarial Mathematics from Dublin City University, and an Investment Management Certificate (IMC) from the CFA Society of the UK. Brian Faley, CFA Indexed Fund Manager Brian is a member of the Indexed Fund Management team, responsible for managing a range of equity and fixed income indexed funds. Prior to joining ILIM in 2012, he spent three years with Johnson & Johnson where he worked in the Treasury department and was primarily responsible for the management of Johnson & Johnson s internal money market fund. Brian graduated from Trinity College Dublin in 2008 with a B.A. Honours Business & Economics degree and received his Chartered Financial Analyst (CFA) designation in The team is also responsible for engaging with clients to understand and explore the roles index strategies can play within portfolios. Shane Cahill Head of Indexed Fund Management, CFA As a member of the Fund Management Executive, Shane holds overall responsibility for our indexation business. He is responsible for the evolution and delivery of indexed solutions to ILIM s international client base. Shane previously held an actuarial role in Irish Life. He subsequently moved to ILIM to take up a quantitative analyst role in which he developed factor models for use in stock selection and country-allocation processes. He also took on fund management responsibilities for equity and countryoverlay portfolios. Shane was appointed Head of Indexed Fund Management in Shane graduated from University College Dublin with First Class Honours degree in Actuarial & Financial Studies in He received his Chartered Financial Analyst (CFA) designation in Shane completed a M.Sc. in Economics from Trinity College Dublin in An Introduction to Factor Investing

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16 CONTACT US PHONE: (01) FAX: (01) WEBSITE: WRITE TO: Irish Life Investment Managers, Beresford Court, Beresford Place, Dublin 1 Irish Life Investment Managers is regulated by the Central Bank of Ireland. Irish Life Investment Managers Limited is registered as an Investment Adviser with the Securities and Exchange Commission (the SEC ). Irish Life Investment Managers Limited holds an International Adviser Exemption in Manitoba and Ontario pursuant to NI This material is for information only and does not constitute an offer or recommendation to buy or sell any investment and has not been prepared based on the financial needs or objectives of any particular person. It is intended for the use of institutional and other professional investors.