Factor investing: Growing pains

15 May 2019

Factor investing is moving into fixed income, but, asks Elizabeth Pfeuti, are investors ready?

When faced with a problem, it is tempting to look for a silver bullet.

Risk factor investing, with supporters including some of the world’s most sophisticated investors, has been put forward by some as such a cure-all for the funding ailments of pensions around the world.

In the guise of smart beta, the approach has taken the equities world by storm. Most major fund managers operate strategies using factors under this terminology, with investors of all sizes and sophistication holding them in their portfolio.

The next big move for the approach is into fixed income, where pension funds are increasingly holding their assets – 50%, according to Mercer’s latest European Asset Allocation survey.

Some of the world’s largest fund houses are muscling in on the action, launching smart beta fixed income exchange-traded and mutual funds over the past 12 months. There are plenty of reasons behind the success of the risk factor approach, according to its advocates.

Replacing expensive active management fees with a passive, factor-led approach has cut pension fund outlay considerably, for example, but cost is not the only thing pulling investors towards this once niche approach.


It is a more instinctive way to invest, according to Tom Idzal, head of North American sales at research firm Style Analytics. He says that until the relatively recent acceptance of risk factors, investors had been given the simple choice of countries, regions or sectors to divide up their stock portfolio.

It is impossible to manage your portfolio exposures unless you know your factor exposures.

Mark Carver, MSCI

“Factor investment is an acknowledgement of the common drivers that go across sectors and countries that tap into something intuitive,” Idzal says.

Risk aversion, a preference for quality, or buying in early to a growth story “are common characteristics of consuming something that is human in nature,” he adds. They can feel more natural than the traditional investment options of choosing a collection of securities based on arbitrary location, size or what a bank has decided sits together in a package.

Investors actions are all driven by something, so it might make sense that companies, which are all made up of people, are driven by something, too.

This method of investment has elevated Denmark’s national pension fund, ATP, to the upper echelons of the pension hierarchy. Even amid the turmoil of the financial crisis – and the gloom beyond – it has generally stayed ahead of its return targets.

The investment team applies the approach across its entire liquid asset portfolio, says Mads Gosvig, ATP’s head of investment strategy. “Our approach is to look at risk from a factor perspective when we invest in equities and fixed income. This helps us identify risk related to market beta as well as non-market beta.”

The fund can see what is driving the return of its securities; whether they are being pushed up or down by something other than the will of the market.

“We want to separate the market beta from the other ‘smart factors’,” Gosvig says. “We have labelled the non-market beta, or ‘smart factors’, our ‘other factor’.”

With this ‘other factor’, the team constructs different trading strategies – long/short, for example – across asset classes, including equities, interest rates, currencies and commodities.

“We invest in global securities and can position our portfolios towards being long risk factors,” Gosvig says.

ATP runs 85% of its money internally, rather than through third party managers. “This way we can be in control – and we don’t want to pay external management fees for something we can do ourselves,” Gosvig adds.

But even ATP realises that factor investing is not the answer for the whole spectrum of assets. Its illiquid portfolios, including private equity, are held in the traditional way. “We hold them on a long-only basis and focus on other characteristics when constructing the portfolio,” Gosvig says. There are other limitations with a factor approach, too.

“It cannot predict,” Idzal says. “It is built on the shoulders of lots of historical data, patterns and strong historical relationships, put together by top academic minds, so it is the best we can get, but it is inherently difficult to use it to predict.”

Multi-factor funds address this by bundling many streams together and switching the weightings between them depending on which is forging ahead as others fall back. This can be helpful, according to Idzal, but it should not be used as a method to predict future returns.

However, even this is only the case – on an industry level at least – for equity investing. The billions of stocks and shares that have changed hands each day over the past 100 years, have built up a solid wall of data. For fixed income, which is traded much less frequently, this information is not available in such great quantities, but there are plenty of people working on it.


What this data can do, however, is hold a lens up to an existing portfolio to gauge where a return is coming from.

“This approach helps investors understand what they are getting into, in terms of strategy,” says Vitali Kalesnik, head of research and business strategy in Europe for Research Affiliates. “A lot of active managers can be selling a promise. Looking at the factors, you can try and understand what will, and will not, deliver.”

Factors give investors the ability to detangle past alpha to see if it was produced by skill or luck.

“This is especially important in fixed income as an investor can comfortably have a lucky bet for 30 years due to very long cycles,” Kalesnik says.

Once an investor has identified where the performance – good or bad – is coming from, they are also better placed to understand the diversification of their portfolio.

Mark Carver, global head of factor index products at MSCI, says that it shows the opportunities and the uncertainty within a portfolio. “Applying this lens is the only starting point,” he adds. “It is impossible to manage your portfolio exposures unless you know your factor exposures.”

Even investors who do not buy into the overall investment approach should realise that the factors are working whether they believe in them or not.


Another point to recognise is that while all factors are created the same, they are not used uniformly.

“Various managers will capture different factors using different signals, so it is important to know what they are doing and how these factors behave,” Carver says. “Some managers might capture the factor on a price-to-book measure, which could give a bias towards a certain sector. These incidental exposures are not trivial. It is important to understand this.”

Gosvig says that if pension funds go to 10 managers running momentum strategies, they must realise that the strategies will all have different outcomes in the short and medium term. “They might all be thinking the same, but there are differences in all their implementation,” he adds.

Equally, ATP does not implement factors in the same way over short and long-time frames.

A lot of active managers can be selling a promise. Looking at the factors, you can try and understand what will, and will not, deliver.

Vitali Kalesnik, Research Affiliates

“In the short term we have to adjust for different volatility,” Gosvig says. “In the longer term we evaluate the strategies and make our decisions and change the metrics as we need to.”

There are increasing numbers of tools for investors to break down their holdings and see which factors are present and how they have moved across an entire (non-risk-factor-labelled) portfolio – and within the market itself.

“There are five or six factors that seem to be the most entrenched or verified by academic research, but we should expect that to change,” Idzal says. “Markets change, preferences switch, technology moves things.” For example, academics have started to ask whether the value premium is still around, at least in its accepted form.

“Should we expect those measures to still be applicable to firms such as Amazon, which have much different capital structures to firms who were dominating in the days when most of the research on these factors was done?” asks Idzal.


The fact that these drivers may fall by the wayside and be replaced by others is a key point to remember, as using the term “risk” for each side of a pension fund’s investment equation has sometimes confused and turned off investors.

There is a danger that they think the risks within a portfolio must somehow link with those on the other side of the balance sheet – the liabilities – which is not the case. The whole of ATP’s DKK785bn (£90.7bn) is not matched to the longevity expectation and retirement income needs of Denmark’s 5.7 million citizens.

Gosvig says that ATP has split its assets into two buckets: hedging and investment portfolios. “The hedging portfolio is a bond and swap portfolio all matched to liabilities. With the investment bucket we are free to do what we want.”

If the fund was not hedged in this way, its risk budget would be eaten up almost immediately. Instead ATP can use leverage on its investment portfolio to make the best returns it can.

“By using it to match our liabilities, we can make the most of the rest of our money by using it as a risk budget for rewarded factor risk,” Gosvig says. “The best way to do this is to diversify, combining the different betas and other factors. It improves our Sharpe ratio and lowers the risk overall.”

But while a better Sharpe ratio and liability hedging seems like the Holy Grail, it comes at a price to do in-house.

“Factor investing is complicated and requires sufficient investment and trading skills and a sophisticated middle/back office to run internally,” Gosvig says. “Finding them externally can be costly. The best place to start is with mandates with a mixture of market beta and other factors.”

Some fund managers have already begun to launch fixed income factor-based approaches, but don’t expect the strategy to catch alight as it has with equites.

Apart from differences in the drivers and how they are captured, the economies of scale work the opposite way in fixed income to equities, according to Kalesnik, which could be a major barrier to the approach’s transfer.

“Larger active equity managers struggle to get performance,” he adds. “In fixed income, this is not the case. “Larger managers can earn alpha as the sector is less uniform and the manager can make a range of selections of securities.”

Additionally, despite a push to trade fixed income on exchanges by international regulators, much is still bought and sold over-the-counter.

“There are large bond houses that have huge legacy products in fixed income, and they are not likely to lose many assets to this approach,” MSCI’s Carver says, adding that analytical tools will help investors better see what they are paying for.

For Idzal, while take up of the approach has soared since the crisis, it is still early days. “We are in the teenage years in terms of helping investors get better transparency and choice – and there is a lot more to go.”

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