Finding the It Factor
Insurers have rediscovered factor investing, with many forecasting an increase in allocations, while others wonder if it’s merely a fad.
- Jeff Roberts
- July 2018
Rising Allocations: Institutional investors increased their factor allocations to 17% of their portfolios in 2017—a hike from 15% a year earlier.
More Choices: There are more than 700 smart beta funds—more than three times the number in 2009.
Size Matters: While factor investing is the domain of large insurers, midsize and small companies are investigating the strategy.
The search for an answer lasted three long years.
It began with a problem. Allianz SE’s equity investments were producing long-term returns, but volatility in some quarters and even half-years.
The German-based multiline insurer needed something more. It started researching new strategies in 1996, seeking stable, relative returns while keeping risk in line with the benchmark.
That mission ended in 1999 when it found a solution that was decades old, yet proved to be ahead of its time.
Allianz’s answer was factor investing.
“We came to the conclusion we had to come up with something that was significantly different from our firm’s typical fundamental, high-conviction portfolio,” said Allianz Global Investors’ Michael Heldmann, head of Best Styles North America, its systematic factor portfolio investing team. “Factor investing was the answer.
“And I think this is what people are coming back to 20 years later. We have seen an uptick over the last couple of years. People have rediscovered this strategy.”
Factor investing has gone from niche to mainstream among large insurers over the past year or two, and many insurance and external asset managers expect allocations to continue to grow.
Allianz’s factor investing strategy was born of need two decades ago—not all that different from the current wave of insurers boosting allocations driven by a similar dilemma: the hunt for yield in a trying environment without taking on substantially more risk.
Historically low interest rates since the financial crisis and equity market volatility have compelled them to seek alternative solutions. They are following in the path trodden by U.S. pension plans and other institutional investors that dove into factor strategies since the crisis.
“We have seen insurance companies more focused on yield in pursuit of sustaining investment returns—whether that’s Schedule BA alternative assets or increasing their equity allocation—because bond yields simply aren’t providing it,” said Holly Framsted, head of U.S. Smart Beta for BlackRock.
“The challenge is the risk that equity allocations contribute to a GA portfolio is large relative to fixed income. So simply buying the market isn’t necessarily the best option for insurers.”
The Core Six
Many asset managers cite six core investment factors as reliable underlying drivers of risk-adjusted higher return, although debate remains. Those six factors are:
Value: Low-priced stocks relative to their valuation. They outperform higher-valued stocks over time.
Momentum: Stock prices tend to continue rising if they are going up, outperforming those that are not.
Size: Small-cap companies generate higher returns over time than large-cap stocks.
Low Volatility: Stocks that possess minimum volatility over time outperform volatile equity shares.
Quality: Companies with dependable earnings growth and low debt outperform their peers.
High Dividend: Companies with higher dividends outperform those with lower dividends.
Hence factor investing.
It employs factors—broad, reliable and persistent drivers of risk-adjusted higher return, such as value, quality and momentum—to embed improved performance and risk management into portfolio construction.
Multifactor investing and its offspring, smart beta—which delivers factor exposure through an index-based product—have capitalized on the industrywide shift from active to passive management since the crisis.
Many investors pulled their money from traditional active managers, citing disappointing performance and high fees. And a good portion have allocated it into factor and smart beta funds.
But not everyone is a believer. Some question if the strategy is yet another fad that will fizzle out, even before it trickles down to midsize and small insurers.
Of course, the concept of factors is hardly new. Buying underpriced stock has always been a core principle of fundamental active management. And the roots of factor-based investing trace back to at least the 1960s, when beta—systematic risk—was the foundation of the capital asset pricing model.
But advancements in technology and data analytics have made identifying opportunities much simpler and cheaper. And they have driven factor investing far beyond merely finding underpriced equities.
Some managers say factor investing has even risen to become the “third pillar” of an institutional portfolio, the alternative to active and passive management. It has driven “a wholesale change in how” managers invest, according to a 2016 Allianz report, Factor-Based Investing Is on the Upswing.
“I have strong conviction that this is fundamentally changing the way investors think about portfolio construction,” BlackRock’s Framsted said. “What is happening is we’re actually redefining alpha [active return]. Alpha now is isolating very idiosyncratic, specific and completely arbitragable sources of outperformance that are truly differentiated.”
"Factors are the language of investments. They're not unfamiliar. They're not new."
Language of Investment
Factors are essentially road maps to finding hidden opportunity.
Investors leverage the observable, quantifiable and systematic characteristics to identify risk premium, structural imbalances or behavioral anomalies and deliver differentiated returns above the market.
The portfolio analysis also seeks to increase diversification while mitigating macro and geopolitical risk exposure.
“Factors are the language of investments,” Framsted said. “They’re not unfamiliar. They’re not new. Demystifying the concept is really the biggest and one of the only barriers to adoption.”
Those drivers include style factors such as value, minimum volatility, quality, momentum, size and high dividend.
Investors also consider broad macroeconomic factors that drive returns across asset classes, such as growth, real rates, inflation, credit, emerging markets and liquidity.
Although equity investments make up a relatively small part of most insurers’ portfolios, they account for a significant portion of their risk budgets. And they are a large overall allocation for the industry.
Factor and smart beta funds offer a hybrid of active and passive management.
“People call factor investing the third pillar because it’s pretty different in what it does for you,” Allianz’s Heldmann said. “It does a piece of what passive does for you—giving you the asset risk premium—but it also gives you something of what active does—long-term attractive results.”
Factor-based equity allocations will continue to grow in the next five years, according to the second annual Invesco Global Factor Investing Study.
Institutional investors increased their factor allocations to 17% of their portfolios in 2017—a hike from 15% a year earlier, the survey conducted by the U.S.-based investment management firm found. Respondents cited reducing risk as the primary reason, with alpha improvements and reducing cost as other motivating considerations.
North American investors increased their allocations to 19% from 16% in 2016—driven by insurers and state pension funds.
Smart beta is the most popular factor product, 66% of North American investors reported.
Those funds surpassed $1 trillion in assets in December 2017. Morningstar monitors more than 700 of them, three times the number that existed in 2009, according to the research firm.
That may explain why CNBC called smart beta “the new face of active investment management” in April. The funds typically charge cheaper fees than active managers, but more than passive products.
There is even growing interest in fixed-income factor investing. Only 32% of investors allocate factors to their preferred strategy, according to the Invesco survey. Issues such as a lack of data and products have posed obstacles.
The large majority of strategies flow into single-factor equity and multifactor equity products.
“The rise in factor investing is the ongoing case of insurers looking for ways to improve the risk-reward profile of their investment portfolios,” said Alton Cogert, CEO of Strategic Asset Alliance, an independent investment consulting firm serving small and midsize insurers. “They’re always looking for possibilities.”
"You need a lot of brain power to make these things really work. It gets complicated. The guiding principle should always be that the market is not giving you something for free."
Proven Track Record?
A single analysis may have led to the rise of factor investing among institutional investors.
An often-cited 2009 academic study sought to explain why the financial crisis inflicted such significant damage to the Norwegian Government Pension Fund.
Its total return in 2008 was negative 23%—including negative 41% in the equity portfolio—reducing its value by nearly $100 billion.
The study, commissioned by the fund, found different investment weights used in stock picking by its managers often cancelled each other out at the aggregate portfolio level, according to authors Andrew Ang (a finance professor and head of factor investing strategies at BlackRock), Yale professor William Goetzmann and London Business School professor Stephen Schaefer.
They also discovered that about two-thirds of the fund’s excess return could be explained by well-known factors, particularly value, size, momentum and volatility.
The study influenced the fund to include core factor philosophies into its strategy, even if it did not fully adopt a factor approach, according to Allianz.
“They basically discovered that after putting a large number of fundamental, traditional equity managers together, they got rid of a lot of the idiosyncratic bets that they truly wanted,” Heldmann said.
“They were left with a portfolio that had these unintentional structural tilts that led to a very unfortunate performance over the financial crisis. So people realized you always have to manage these factor effects in your portfolio.”
Then Eugene Fama won the Nobel Prize in Economics in 2013 for his analysis of value and size as risk premiums in outperforming the market.
The Norwegian Pension Fund investigation and studies by Fama and Dartmouth finance professor Kenneth French are among the highly regarded academic research proving the role investment factors play in any aggregate portfolio’s performance.
“You have so much more structural support and academic research behind it compared to the pure bottom up, stock picking traditional managers,” Heldmann said. “The potential for disappointment is also lower in the end. It is really something close to the index plus an attractive but credible return on top of it at a very comparable level of risk.”
The concept of factor investing may be simple. The execution is not.
“Factor investing can get really complex really fast,” Cogert said.
That is why the strategy has largely been the domain of external managers and large insurers using their asset management arms.
For example, BlackRock manages nearly $200 billion in factor strategies, $90 billion of which is in smart beta ETFs, it said. It launched its first factor fund in the early 1990s and its first factor-based ETF in 2003.
Vanguard launched six factor-based ETFs and a factor-based mutual fund in February. And Goldman Sachs and Fidelity recently added additional smart beta funds.
Allianz manages more than $52 billion in factor strategies, with about a quarter of it for its parent. The rest it manages for external companies, including “significant business with other insurers,” Heldmann said.
“You need really big scale,” he said. “And you need a lot of brain power to make these things really work. It gets complicated. The guiding principle should always be that the market is not giving you something for free.
“You’re taking on additional risks. And very often you need sophisticated risk management. Otherwise you can get into areas where things could hurt.”
Given the structure of most U.S. insurance portfolios, the number of insurers “utilizing pure factor investing as defined today may currently be low,” said Lisa Longino, senior managing director and head of insurance asset management, MetLife Investment Management, in a statement.
“However, insurers have been employing variations of factor investing for many years as they look to diversify their portfolios and pick up incremental return.”
A growing number of midsize and small companies have begun to investigate the strategy, even if it has not yet resulted in significant allocations.
“The smaller ones are definitely interested,” Heldmann said. “We don’t have so many smaller insurance companies as clients, but there is a lot of demand for educational content and meetings.”
They lag behind larger insurers with more resources to implement strategies in these “early days,” according to Framsted.
“But we have seen adoption across a spectrum of insurance company sizes,” she said. “The smaller and midsize insurance companies actually stand to benefit more when we think about the true value add of ETFs, because they are less likely to have the robust teams of portfolio managers managing equity assets.”
However, SAA’s Cogert has not seen the same interest among his clients. The small- and midsize insurers who have employed factor investing “would be in the deep minority,” he said.
“We’re on the beginning of the curve,” added Cogert, whose Washington State-based firm has about $11.7 billion in assets under advisement. “One of the quote-unquote hot strategies is factor investing. But the question is, will this fizzle out or just stay among the larger insurers that basically have to be as diversified as they can?
“Or will it indeed filter down to medium and smaller companies? So far, I don’t think it has to any great degree.”
Cogert is not alone in wondering.
Critics warn that factor returns might not be as strong as forecasted. Some worry that the scope of factor investing has been stretched too far and has lost its focus.
And others predict whatever advantages factor exposure offers will quickly be arbitraged out. In fact, some have said that there are already signs of it with valuations increasing.
J.P. Morgan Asset Management noted in March that “the rise of factor investing has sparked excitement as well as angst across the investment community.”
“Conceptually, it makes sense. But if there’s an anomaly in the markets, if everybody knows about it, it quickly gets arbitraged away,” Cogert said. “That’s why if there’s a really good idea out there, you won’t hear about it until it’s too late.
“I keep that in the back of my mind whenever a manager says, ‘Hey, I’ve found the golden ticket!’ OK, why are you telling everybody about it?”
Other questions include: Will factor investing work in all environments and how applicable are those historical studies, given how much financial markets have changed?
Heldmann acknowledges there is risk.
“People know that in the very long run if you always buy cheap stocks—value factor—you outperform,” he said. “But there can easily be 10 years of underperformance of that factor. Now that is obviously something that the classic insurance companies are not going to sustain.
“That’s what makes them hesitate. They see that it doesn’t work all the time. And even though a well-constructed multifactor strategy paired with sophisticated risk management can help mitigate some of those risks, some will always remain. This is a good thing because it means it’s not an inefficiency that could be arbitraged away.”
Framsted argues the strategy is here to stay. She expects many investors will continue to transition from fundamental active managers to factor-based smart beta ETFs.
“I don’t see it fading out,” she said. “Factors work for reasons that tell us they shouldn’t be arbitraged away.
“And factor-based investments and smart beta ETFs are offering tangible solutions to real client problems. We’re seeing a commoditization of strategies that have been around and invested in for a long time, which is why I don’t think there’s any chance of it going away.”
(Jeff Roberts is a senior associate editor. He can be reached at firstname.lastname@example.org.)