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Introduction to Factor-Based Investing

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factor based investing

This article is sponsored by S&P Dow Jones Indices.

For decades investment portfolios have been constructed from a combination of cap-weighted index funds and active funds. Cap-weighted index funds allow investors to acquire the market portfolio in a simple, transparent, and cost effective manner. By contrast, active funds promise higher returns at the cost of greater complexity and higher fees.

In recent years institutional investors have employed a new approach to portfolio construction: factor-based investing. This increasingly popular approach lies between the passive and the active, allowing investors to target specific risk factors (return drivers) as well as market beta. These strategies use a transparent, systematic rules based approach, at relatively low costs.

The origin of factor-based investing can be tracked back to the linear Capital Asset Pricing Model (CAPM), one of the first financial theories to model asset returns as a function of factor risks. Formulated in the 1960s, it stated that there is only one factor, the market factor, driving the returns of assets.

Moreover, the CAPM framework highlights two sources of risk within any portfolio, one systematic, the other specific. This has important implications for portfolio construction. First, the specific component can be diversified away by holding many assets. Second, the systematic risk is a function of the portfolio beta and market risk. CAPM reveals valuable insights behind the mechanics of investment performance, namely that expected returns of assets are proportional to their systematic risks as measured by their betas. On the other hand, specific risks can be diversified away and are not rewarded with excess returns.

By the 1970s additional factors were introduced to improve CAPM as a risk tool. The first multifactor model was developed by Stephen Ross in 1976. Many of today’s commercial risk models are based on his Arbitrage Pricing Theory (APT), including macroeconomic factor models, fundamental factor models, and statistical factor models.

Pricing anomalies were soon discovered that contradicted CAPM and its use as a pricing model. The Fama and French three-factor equity model, incorporating the size and value effects in addition to the market, was widely regarded as an improvement . An extension of this three-factor model is the Carhart four-factor model, where the momentum effect is included . From a practitioner’s point of view, this highlights that there may be other priced factors, in addition to the market, that will reward investors over time. These factors drive the performance of investment portfolios. They underpin many of the factor-based products currently available in the market.

Pricing factors such as value, momentum, and quality have provided excess returns within the equity domain. The same principles are increasingly applied to commodities where factors such as roll yield and momentum are popular. Awareness is growing within the fixed income sphere too. Portfolios that target factors such as the term, credit, and high yield spreads are likely to follow. Within asset classes, factors can be combined to target multiple exposures – a multifactor approach. When combining factors, cross correlations can reveal diversification benefits improving portfolio risk return characteristics.

It seems inevitable that practitioners will continue to utilise and develop factor-based products, due to their transparent and systematic rules and relatively low costs. The next few years will be interesting.

The Story of Factor-Based Investing research paper is available at: Research Paper.


1 Fama, E.F. and French, K.R., (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics. 33 (1), 3-56.
2 Carhart, M.M., (2012). On Persistence in Mutual Fund Performance. Journal of Finance. 52 (1), 57-82.

 

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How Do Public Pension Funds Invest?

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This article is sponsored by State Street.

Public Pension Funds (PPFs) are highly idiosyncratic and distinct from other types of institutional investors. The universe of investors that fall within our definition of a PPF is numerous and varied. We count 115 institutions in 70 jurisdictions, diverse in geography and economic development. For the purposes of our study, we examined the top 16 funds whose assets constitute just over two-thirds of the total universe. Despite all the idiosyncrasies of PPFs, we have found some shared characteristics in the evolution of their asset allocation over the past decade.

According to our definition, PPFs held around $5.9 trillion in total assets of 2016 and over 4% of all publicly traded assets, making them a significant global investor group. In particular, given their preferences for specific asset classes, their share is disproportionate in some segments. For example, we estimate that by year-end 2016, PPFs owned over 7% of global tradeable fixed income assets (including 8% government bonds and over 13% of inflation-linked bonds) and over 3% of listed public equities.

Similar to other asset owners, PPFs have undertaken a major reallocation of assets over the past decade. However, the motivating driver has not only been the low yield environment, but also changing regulatory and macro policy settings, which either permitted or encouraged greater diversification along asset classes and geographical exposure.

In detail, the most dominant trend has been the move away from holding domestic (local currency) bonds; in their place, PPFs have redeployed assets towards equities and alternatives, with a small share also diverted into foreign bonds. These allocation trends have been almost universal despite a huge diversity of geography and economic development.

It is important to acknowledge how much this investor group has changed over the past decade, with the asset pool growing by over 40% in dollar terms, and even more if measured in local currencies. While some funds are still predominantly captive buyers of government debt, the bulk of PPFs have been transforming into financial institutions with independent firepower and income-generating capacity. The long-term trend towards more diversified fixed income portfolios is likely to continue, as is the shift towards taking on more risk via equity allocations, subject as ever to changes in market cycles. In this context, we expect most PPFs to not only continue taking on more risk overall, but to further internationalise their portfolios.

Finally, one consideration is that maturing funds catering for aging populations will have to make further adjustments to their asset allocations to account for changing cash flow directions and seek greater contributions and investment returns to bridge any funding gaps.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.

Tracking Code: 2172159.1.1.GBL.RTL

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Authors
Elliot Hentov, Ph.D. Head of Policy and Research, Official Institutions Group Elliot_Hentov@ssga.com
Alexander Petrov Policy and Research, Official Institutions Group Alexander_Petrov@ssga.com
Sejal Odedra Business Analyst, Client Strategy, Official Institutions Group Sejal_Odedra@ssga.com

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The Slings and Arrows of Passive Fortune

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This article is sponsored by S&P DJI.

If a tale were to be written regaling us with the popular exploits of the modern day active manager in his quest for alpha across the many peaks and valleys of the financial world, passive investment would likely feature prominently in the telling. Passively managed assets have grown tremendously since their introduction in the 1970s to command some 20% of the U.S. stock’s market total-float adjusted capitalization, drawing a deluge of criticism in recent years from proponents of a more traditional, active approach who charge indexers with all manner of supposed ills – from encouraging collusive behavior and exacerbating pricing inefficiencies, to indifference on matters of corporate governance.

But are passive assets and their purveyors really the threat to markets that active management makes them out to be? Or are the problems attributed to their rise merely a reflection of the market forces all participants must face? These are the questions posed by Anu Ganti and Craig Lazzara at S&P Dow Jones Indices (S&P DJI) in their new paper, titled “The Slings and Arrows of Passive Fortune,” which seeks to unravel some of the most pervasive myths surrounding the growing role of index funds, highlight the immense value they bring to asset owners, and posits a future of asymmetric equilibrium between the old and the new that puts each in their proper place based on relative – rather than absolute – performance.

Nobody – including the paper’s authors – denies that index-based investment has made life more challenging for active managers, who count alpha as their very lifeblood; but so too would it be foolish to argue its advancement as one of the most important developments in modern financial history is without merit, or somehow Thucydidean in nature. If anything, active management can and should expect its portion of the pie (which, it must be pointed out, constitutes the majority of assets by a wide margin) to remain subject to nibbles from their passive counterparts – nibbles that may, with time, diminish. The market always has room for more players at the table, after all, and we all play by its rules.

As Director and Managing Director of index investment strategy team at S&P DJI, Ganti and Lazzara provide research and commentary on the firm’s entire product set – covering U.S. and global equities, commodities, fixed income, and economic indices. Both are chartered financial analysts and regular contributors to Indexology, S&P DJI’s appropriately named blog covering developments in the world of indexing.

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Battea: 2017 Securities Class Action Industry Lookback and Observations

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This article is sponsored by Battea.

Source: Battea

There has been incredible growth in securities and antitrust class action litigations and settlements, particularly as they have unfolded in 2016 and 2017. The number of new cases and settlements from traditional securities litigation to antitrust rate rigging, spread inflation and other forms of collusion are at an all time high and shows no signs of slowing down.

With several multi-billion dollar litigations related to Libor, Euribor and Tibor rates, and spread manipulations, the securities, foreign exchange and antitrust class and collective actions litigation space rose exponentially in 2017.

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