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.
2 Carhart, M.M., (2012). On Persistence in Mutual Fund Performance. Journal of Finance. 52 (1), 57-82.
The Slings and Arrows of Passive Fortune
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.
Battea: 2017 Securities Class Action Industry Lookback and Observations
This article is sponsored by 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.
View Whitepaper Here
The Future of Operations: Simplify, Innovate and Transform
This article is sponsored by Broadridge.
Now that the pain of the global financial crisis and subsequent regulations are starting to fade from view, the asset management industry is facing new challenges that will transform the business. Firms must be nimble enough to support this evolution. That means not only redesigning operations, but also adopting new technologies that can be used for innovation in-house and with the help of partners.
In active management, the industry has created more complex products to generate alpha, while the growth of passive management, spurred by fintech competition, is compressing fees. At the same time, expansion into new markets has added costs. Facing these challenges will require serious improvements to back- and middle-office operations — an overhaul of everything from data validation to trade reconciliation.
For this type of transformation, experts say, it’s not enough to improve the steps in a process. Financial institutions need to eliminate steps. Specifically, executive members of the Asset Management Group of the Securities Industry and Financial Markets Association (SIFMA) say that leading firms should:
Work collaboratively. Firms should collaborate to solve common problems; use associations to identify and promote best practices; and partner with service providers, utilities and regulators to tap their specialized skills and mutualize non-differentiating functions.
Tackle common pain points. Many of the industry’s biggest challenges come from a lack of standardized processes: Standardizing data is the top challenge and sets a foundation to accelerate change.
Leverage transformational technology. Cloud computing, artificial intelligence, and distributed ledger technology can be transformational over the coming three, five or 10 years — but investing now is vital.
Assess, accept and mitigate risks. During times of large transformational change, it should be understood that risks are higher. This traditionally risk-adverse industry must balance the need for bold change against the fear of producing subpar outcomes.
This paper asks how asset managers can move beyond incremental improvements, like shaving costs from processes like post-trade settlement, regulatory compliance and reconciliation, to reimagining how operations are handled. Based on discussions with executives from leading asset management, buy-side, and sell-side firms, as well as service providers, it assesses the drivers for change and the challenges and opportunities ahead, and discusses what actions the industry must take to reach its desired future state.
The long-term vision of how asset management operations should change is best summed up by one word: Simplify.
To learn more about “The Future of Operations” for the asset management industry, download the white paper from Broadridge and the SIFMA Asset Management Group.
To learn more about Broadridge’s solutions for the asset management industry, please visit www.broadridge.com/financial-services/asset-management/
3 weeks ago
HQ Capital Raises Money for U.S. Real Estate
3 weeks ago
Russia-Japan Investment Fund to Back Wood Pellet Production in Russia
3 weeks ago
Is Franklin Templeton the Private IMF for Argentina?
3 weeks ago
Oman Infrastructure Investment Fund Near Creation
3 weeks ago
Gulf Japan Food Fund Buys Majority Stake in Country Hill International
3 weeks ago
Red Sea Project Gets Former Canary Wharf Veteran
1 week ago
CPPIB to Become First Major Pension to Issue Green Bonds
3 weeks ago
SWFI First Read, May 29, 2018