Andrew Peach, senior consultant, Aon
Factor investing in equities has been a rapidly expanding segment of the investment universe and we expect this momentum to carry on as implementation methods and research evolve.
This is an area to which Aon has dedicated significant research and we have witnessed significant growth in investor awareness, demand and breadth of investable options.
One of the reasons it has grown in popularity is that it enables investors to target active-like returns at passive-like fees – an outcome which is clearly very appealing. The added benefit of its transparency has seen the trend accelerate.
The growth in interest has led to the obvious question being asked: can the same methods be employed within fixed income markets?
The application is still in its relative infancy within bond markets and, while there is encouraging evidence that it can add value, it is clear that such an approach faces challenges when compared to equities.
In the case of equities, there is a wealth of available information on companies and historic stock price movements which can be used to determine common attributes and create rules for investing in a systematic, transparent and low cost way.
Bonds, by their nature, are not so clear cut. A company may issue several bonds with different maturities, different covenants and potentially different currencies. Add to the mix that they mature, further limiting the availability of back history, and it becomes clear that there are significant challenges in terms of availability of appropriate data.
Bonds are also traded in a different way, not on exchanges but over-the-counter which means there is reduced transparency on availability and price (albeit this has improved in recent times).
This reduced visibility means that liquidity and transaction costs will likely need to be carefuly controlled within index construction.
What about investor motives? At a high level, the ‘market’ risks taken by investors are duration and default risk. Investors expect a higher return for accepting the greater price variability of longer-dated bonds (duration risk). Similarly, investors expect a higher return for accepting a higher risk of a given entity defaulting on their commitments (default risk).
In the UK, from an institutional investor perspective, more and more pension schemes are accessing duration through leveraged liability management strategies aimed predominately at risk reduction rather than adding value. To an extent, this trend has also cannibalised interest in traditional credit indices given that risk premia no longer need to come with duration attached.
However, factors do not need to be tied to a specific benchmark and there have been strides within the fixed income market to apply similar factors to those employed in equity markets (value, low risk, quality and size) to add value in a wide range of market conditions. We believe this will be of genuine interest to investors.
The challenge, given the inherent data and market difficulties, will be ensuring that these products maintain the key benefits that have seen factor investing in equities become so popular – namely transparency and cost efficiency.
