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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 Does Geopolitics Affect Financial Markets?

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This article is sponsored by State Street Global Advisors.

In Alexandre Dumas’s 1844 novel The Count of Monte Cristo, news of an impending cross-border revolution in Spain leads to financial panic among French investors. Some investors end up selling Spanish bonds at a great loss, only to see the price bounce back after the news proves to be erroneous.

Geopolitics matters to markets in the real world too and has been a major theme in 2018, as the post-war global order is dismantled and protectionism takes hold. But, as in Dumas’ tale, it can be hard for investors to know how to react to such uncertainty. In this paper, we examine attempts to assess the impact of geopolitics on markets and conduct our own analysis on how it plays out over different time periods. Our hope is that investors can use this analysis when considering how best to respond to future geopolitical events, in terms of both the risks and opportunities they may present.

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By clicking on the link to view the report, you acknowledge you are an institutional investor or other accredited investor.

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Through the looking glass

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This article is sponsored by Dominion.

The decision taken by the British Government to require the 14 British Overseas Territories (BOTs) to establish Public registers of the beneficial owners of Companies registered in these territories has so far created a divided reaction. The BOTs, have generally taken the view that it is grossly unfair for the UK Government to use ancient Constitutional rights to impose the new legislation whereas the Crown Dependencies who are not affected by this decision have unsurprisingly provided a more measured response. This is reflected by Deputy Gavin St Pier in statements very similar to those issued by Politicians in Jersey stating that ‘Guernsey will introduce a public register if that becomes the agreed global standard.’

Gavin St Pier’s words have I am sure been chosen carefully since the body that has the necessary authority to end this debate is The Global Forum on Transparency and Exchange of Information for Tax Purposes (Global Forum) that has been the multinational framework within which work in the area of transparency and exchange of information has been carried out by both OECD and non-OECD economies since 2000. The Global Forum is the only international body endorsed by the G20 on issues of transparency and Exchange of Information for tax purposes.

So what does the Global Forum have to say on this issue. Well, paragraph 14 of the report of the Plenary Meeting of the Global Forum held in Cameroon in November 2017 states ‘The second round of peer reviews launched in 2016 reflects the latest developments in international tax transparency, including the requirement to have beneficial ownership information which strengthens the fight against anonymous shell companies and the use of legal arrangements to conceal ownership of identity.’ So reasonably one might expect, this issue should already have been dealt with. Unfortunately not it seems. The information sharing framework created by the Global Forum is designed as an exchange of information programme between Governments. Information exchanged is not available to the Public. So therein lies the problem. Public disclosure of beneficial ownership, despite what paragraph 14 might say, does not appear to have been clarified by the Global Forum, leaving it to Governments, pressure groups and other Organisations around the World to set the Public Agenda on this thorny subject.

Hopefully at this years Plenary Meeting of the Global Forum guidance will be provided on this issue that will feed through into legislation in all Countries that have adopted CRS. In the Plenary Meeting in Cameroon it was noted that ‘Some Members expressed concern that the ongoing EU listing process (referring to a proposed blacklisting of certain jurisdictions by the EU) is occurring outside the framework of the Global Forum… Statements like this would not I imagine encourage the Crown Dependencies to make further comment on this issue or to take any specific action as the Global Forum is clearly through these remarks reinforcing it’s mandate granted to it by the G20. The direction of travel, if one considers EU anti-money laundering Directives and bodies such as the EITI of which the UK is an important Member, would appear to favour a new regime creating a framework for Public Disclosure but when and in what form all stakeholders in this process will just have to wait and see what develops and whether the Global Forum will opine and then issue model legislation on this important issue.

To read more on this subject please visit: expertsinwealth.com/globalregisters

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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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