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Implementation Considerations For Factor Investing

Mar. 06, 2018 10:34 AM ET1 Comment
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Investors of large pension funds or insurance companies should care about factors. They are systematic drivers of portfolio risk and return and at the heart of risk management tools. A more recent offering is the introduction of smart beta or factor-investing techniques to the allocation decision of many institutions [1]. This approach aims to incorporate factors (such as Value, Size, and Quality) to enhance portfolio diversification and performance relative to traditional market-cap indexes.

Traditional portfolio and asset allocation techniques typically performed poorly in 2008. The Norwegian Ministry of Finance commissioned an in-depth study of the fund by Ang, Goetzmann and Schaefer (2009) [2]. They found that a major part of the fund's active returns before, during, and after the financial crisis could be explained by static exposure to systematic factors and that it may be possible to reproduce such outcomes using passive management approaches. The report recommended that the Norwegian Government Pension Fund should go beyond traditional asset allocation techniques, across asset classes and geographies, and incorporate factor investing.

There are several reasons why an investor may decide to follow a factor route. Traditional passive investments offer advantages of high capacity and liquidity, high transparency and low implementation costs. But there are also risks: price being the driver of index returns1, cap-weighted indexes exhibit exposure to risk factors such as momentum, (large) size and (poor) value stocks. They may also exhibit periods of concentration - e.g., Japan in the 1980s and during the Internet Bubble in the 1990s. Factor-based investing can address these issues by targeting exposure to factors a plan believes will be rewarded in the long run. Single factors display differing sensitivities to macroeconomic events and combinations of cyclical and defensive factors can be used to target different outcomes, from reducing downside risk, improving diversification to enhancing risk-adjusted returns.

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