By Guido Baltussen and Bas Peeters
Academia has brought us a clear message: returns on portfolios are, in particular, the result of exposures to various structural drivers of returns (or factors), and allocating to the factors explicitly helps to improve the performance and risk control of portfolios. This practice is also labelled ‘factor investing’, and is nowadays increasingly adopted by institutional investors.
This raises the question what are then relevant factors to which an investor should pay attention or allocate to? First, we have the traditional asset class or market factors, like the equity market factor and the bond market factor. Second, there are factors that we term “alternative premia”; drivers of return not reflected in a particular buy-and-hold investment of an asset class, but in various dynamic patterns in assets and generally present across markets.
Based on academic and extensive in-house research, we have identified five alternative premia; momentum, value, carry, flow and volatility. These factors drive returns because they (i) offer exposure to risk that other investors wish to avoid (a risk transfer, similar to the idea of insurance premia), (ii) profit from systematic mispricing opportunities created by investors’ behavioural biases (a market inefficiency), and/or (iii) provide compensation for accommodating market imbalances (a market structure compensation). These premia are generally present ‘across the board’ (that is, in equity, bond, FX, and commodity markets) and are well-exploitable in liquid universes.
To get a sense of what factor investing means, it is useful to compare it with nutrients intake. If we take a hamburger, we can look at what we put on the burger: the ingredients (being bun, meat, lettuce, etc). This view gives a sense of the ingredient mix; we have (roughly) 45% bread, 30% meat, 10% lettuce, etc. Although the hamburger may look good and healthy from this perspective, it does not necessarily mean the mix fits well in the context of your optimal nutrients need.
Alternatively, we can look at what drives the “impact” of the burger: the nutrients. A typical hamburger contains 69% of the recommended daily intake of fat, 17% of the recommended daily intake of carbohydrate, etc. Generally, it is the nutrients that matter the most and drive health.
In terms of an investment portfolio, the “ingredient view” corresponds to focusing on typical investment categories, like US equities, Europe credits, etc. This view gives a sense of the portfolio composition, but it does not necessarily mean the mix fits well in the context of your investment objectives. By contrast, the “nutrient view” tells us our actual portfolio composition and diversification in terms of factors that drive return.
The central point of factor investing is that just as how eating right means looking through ingredients to understand nutritional content, investing right means looking through investment labels for the underlying factors. Factor investing is the practice of actively steering on the “nutrients” (the factors), or in other words, allocating to factors as building blocks of a portfolio.
Factor investing is beneficial by accommodating a more efficient allocation of risk; It involves focusing on the “true” structural return drivers of a portfolio, and therefore harvest performance drivers in a more diversified, effective and generally lower cost manner.
Our research shows that allocating to these factors across various portfolios offers attractive reward potential and better diversification, helping to improve the risk-return profile of a portfolio. Over roughly the last two decades, multi factor solutions in either fixed income, equity or multi-asset spaces enhances the net returns of a typical portfolio by about 1 to 3% per annum for only a 10% allocation to the alternative premia. In addition, the diversification of the portfolios improved while both volatility and drawdowns decreased significantly.
Guido Baltussen is senior strategist and Bas Peeters is head of quantitative research & strategy at NN Investment Partners.
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