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Introduction to Factor-Based Investing

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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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Transforming Saudi Arabia’s Capital Markets

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This article is sponsored by State Street.

KEY POINTS

– Vision 2030 and the Aramco privatization mark a decisive point to advance Saudi Arabia’s financial sector — a critical ingredient to the country’s economic transformation

– Saudi’s “Financial Triad” remains partially incomplete with a sound banking system and a rapidly emerging equity market, but an immature bond market.

– The privatization of Saudi state assets (including Aramco) could deliver a boost to the depth and sophistication of the Saudi equity market and — if cleverly designed— have positive spillover effects into other areas of finance and policy.

– The timing is ideal to launch an accompanying systematic drive to build local currency bond markets, which is a prerequisite for achieving the broader economic goals of Vision 2030.

Saudi Arabia’s Vision 2030 is remarkable in its aspiration to engineer far-reaching economic transformation. As a global asset manager, we note that one of the three pillars of this vision sets out the aim to make the country a “global investment powerhouse.” 1

While Saudi Arabia has a strong legacy as a sovereign investor in foreign markets, this ambition also requires its local financial system to deepen across all sectors. Strong capital markets work together with a banking system to channel investment and ensure efficient capital allocation across the economy. In the absence of such channels, many worthwhile business ventures never take place, capital is misallocated and underutilized, and economic growth remains below its potential.

To read the full study please click here.

1 Foreword to Vision 2030, http://vision2030.gov.sa/en/foreword.

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Sovereign Wealth Funds as a Driver of African Development

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This article is sponsored by Quantum Global.

Sovereign wealth funds (SWFs) are becoming important sources of development in many countries. African SWFs have been growing in recent years, as many countries joined the international trend in establishing SWFs, while many others are preparing to join. Growth of SWFs has been driven by rising commodity prices until 2014 and improving economic growth rates. At the same time, Africa continues to face a number of development challenges, raising the question of whether SWFs can play a role in fostering economic development on the continent. This paper analyses the dynamics and role of SWFs in promoting development in Africa. The paper notes that SWFs can play a more active role in Africa’s development by bridging the infrastructure funding gap, supporting industrial development and economic diversification, reducing macroeconomic volatility and enhancing intergenerational equity. For SWFs to be effective in delivering their mandates and supporting economic development, they need to have clear goals and objectives, improve their governance and transparency frameworks, improve their risk management frameworks and embrace the Santiago Principles. African governments need to develop more attractive frameworks and climates for SWFs to invest in the continent, especially in sectors that contribute more directly to addressing Africa’s development needs.

To read the full study please click here.

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Collateral: The New Performance Driver

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This article is sponsored by BNY Mellon.

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In 2017, the global buy-side community faces considerable liquidity and funding pressures, stemming from market and regulatory reforms that are causing disruption. As a result, access to high-quality collateral, funding and liquidity is not only a pressing concern but has emerged as the essential new performance driver for the buy-side.

This disruption is the result of two opposing forces. Stringent regulatory requirements are forcing market participants to seek collateral — generally of high quality — in order to secure trading exposures. At the same time, the sell-side — or dealer-sponsored financial plumbing used to supply liquidity and collateral to the market — is experiencing challenges due to Basel III capital and liquidity constraints.

A major concern among multiple buy-side firms is that the next market-stress event will occur not because of a lack of collateral in the financial system but rather due to the inaccessibility of this collateral.¹ This scenario is forcing firms to reevaluate their collateralized trading portfolios, recalibrate asset allocation strategies and in some cases review the investment products offered to end clients.

This paper presents the findings from BNY Mellon–PwC outreach to senior buy-side executives from over 120 global firms conducted during the first quarter of 2017. It provides insights on demand-supply imbalances that are being experienced by buyside firms and the possible solutions they are exploring in response to fears that ready access to liquidity and high-quality collateral may become scarce in the years ahead.

The picture that emerged from these discussions was one of a buy-side community both grappling to adjust to its new collateralized trading obligations as well as striving to secure access to sustainable sources of funding and liquidity.

To read the full study please click here.

1. Collateral can be inaccessible due to decreasing velocity of collateral, which indicates how much, on average, a single dollar of collateral is reused over a period of time. This is analogous to the concept of “velocity of money.”

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