by Wietske Blees*
Factor investment strategies are on the rise among Australian asset owners, with multi-factor strategies proving particularly attractive. However, while available research shows significant long-term risk/ return benefits, implementation hurdles remain considerable and errors can be costly.
Stephen Quance, Asia Pacific director of factor investing at Invesco has noticed a significant uptake in factor investment approaches among asset owners globally, and Australia is no exception. “At the core, factor investing is an advanced investment technique based on quantitative evidence-based research, so it’s generally the most progressive sophisticated investors that are most advanced in taking this up. In Australia, many of the superfunds fit that profile,” Quance said.
While many investors look to single factor approaches, there are also significant segments – particularly among larger investors with significant scale and lower cost ratios – that are looking to factor investing as either a portfolio risk management tool, or as a different way of thinking about portfolio allocations. These are the types of institutions that favour multi-factor approaches, which combine different factors, thereby providing for additional diversification, as well as better control of risk, factor tilting, and enhancement of performance. Customised factor strategies are used to create additional capacity for low tracking error alpha generation, while skilled fundamental managers may focus on more concentrated portfolios.
“When we’re talking to funds, the multi-factor approaches is where most of the interest lies. Having a multi-factor approach makes a lot of sense particularly when you care about things like Sharpe Ratios and drawdowns,” Quance told Fund Business.
By being more granular, the multi-factor approach is better suited to investors that look for a more nuanced view of risk, but the increased diversification that exposure to different factors provides has also proven beneficial of late.
“Over a long period of time we tend to see that momentum and value, or momentum and quality can have some fairly negative or low correlations to each other, so if you create a multi factor strategy and you diversify across factors, the overall portfolio has a much smoother ride,” Quance said.
First State Super is a superfund with about $90 bn of assets that has been allocating significantly to internal multi factor investment strategies since 2017. Eben van Wyk, portfolio manager at First State Super, joined the asset owner in 2015 to set up their active systematic process, essentially building a platform that combines various proprietary factors with customised portfolio construction to suit their fund objectives.
Like Invesco’s Quance, van Wyk favours the multi-factor approach.
“In recent years, there has been this deconstruction where the building blocks of an active quant process can now be bought independently at low cost. You can buy the value factor, the growth factor or the momentum factor separately, but to me, combining differentiated factors in a smart way is still the way to go,” he said.
Shorting is not common among superfunds, and they tend to operate under many investment restrictions. A creative approach to multi-factor exposures can mean they get the best of all factors. For example, while a pure value play would include poor quality underperforming stocks, combining value, quality and momentum could allow for a more sensible portfolio, providing additional diversification and returns.
“The multi-factor approach allows you to use the best of different factor elements. You can combine different characteristics of stocks to diversify between different sources of return, whether they are alpha or risk factor premia,” van Wyk said.
First State Super’s platform is now being customised to ensure factors can be combined in a way that better suits the funds’ risk profile and objectives in terms of both accumulation and retired members. “This is the really interesting part, where you can use all the tools that are available to you as a quant to build a product that’s going to suit your firm or your client. It could be the risk profile, it could be drawdowns, but it can also be about tax effectiveness or alpha,” van Wyk said.
Designing a multi-factor portfolio is not without challenges. For one, more factors mean more complexity. To build a multi-factor portfolio you need a portfolio optimiser that not only reflects the predictions, but that also operates within the constraints of the mandate. Superannuation funds face the same challenges as fund managers when implementing investment strategies that aim for above-benchmark returns while avoiding unnecessary risks, for example controlling tracking errors and sector exposures, tax implications, stock limits and minimising unnecessary turnover to ensure transaction costs don’t wipe out the expected returns.
While by no means impossible to implement, this does require significant inhouse expertise. Similarly, it’s important to understand the impact of a factor-based approach on the risk profile of the overall portfolio.
Invesco’s Quance said it is important to understand that factor investing is a long-term commitment. “It’s a fundamentally different approach to investment decision making. For example, while traditional investment is typically a zero-sum game, that’s not necessarily the case in factor investing, particularly if the factor is there because it is a risk return trade-off. Instead, you have to consider other issues, such as capacity and crowding, and that in turn has implications for the due diligence you run, the skillsets required, and the systems that are put in place,” Quance said.
Of course, there’s no need for asset owners to take all this in house. It’s also perfectly possible to buy a factor-based exchange traded fund, partner with a fund manager in building customised solutions or ask a sell side bank to execute the strategy on your behalf.
As one local quant manager specialising in factor investing at a large superannuation fund told Fund Business: “I don’t think that as an asset owner you necessarily have to aspire to be an asset manager. You do the things that make sense to do internally, where there are big cost benefits or there is a clear IT benefit to be had, but if the external world can do it cheaper for you then it makes perfect sense to outsource. In the case of factor investing, unless you have significant benefits of scale, I’m not sure it’s worth the cost and effort required to set up a trading floor, employ the right people and run all that operational risk.”
Factor implementation will be discussed in detail at the second ‘Investment Implementation Summit’, hosted by Fund Business, on March 28 in Sydney. (https://www.fundbusiness.com.au/investment-implementation-summit). Weitske Blees is the editor at Fund Business.