“Why limit yourself to the equity premium,” asks David Blitz, Head, Robeco Quantitative Equity Research, “when there are systematic factor strategies that outperform market-cap-weighted benchmarks?” Recent research from Robeco looks at how to translate the theory of factor premium investing into practice.
Innovative institutional investors are reassessing their equity portfolios. David Blitz, speaking at Robeco Summer University 2012 in Madrid, described how research by academics and pensions funds is providing the basis for a transition to a new way of thinking about strategic equity allocations.
One of the most influential studies was conducted for Norges Bank Investment Management (NBIM), which is the largest pension fund in the world and responsible for managing Norway’s oil wealth. The research began as a long-term evaluation of the pension fund’s active management strategies.
Three distinguished academics, Andrew Ang (Columbia Business School), William N. Goetzmann (Yale School of Management) and Stephen M. Schaefer (London Business School) produced a comprehensive report revealing that approximately 70% of all active returns to NBIM since its inception in 1998 could be explained by exposures to various systematic factors.
While evidence of a return from active management was appreciated, the analysis exposed that the source of the return was actually a byproduct of bottom-up security selection.
The authors recommended that NBIM begin using “a more top-down, intentional approach to strategic and dynamic factor exposures.” While NBIM has not yet followed this advice, strategic allocation to factor premiums was subsequently dubbed “the Norway model.”
Other large pension fund managers, however, have taken action. PGGM, for example, which manages EUR 100 billion for the Dutch health care sector, was a first-mover. It restructured its equity portfolio in this direction some time ago, allocating 40% of equity holdings to three factor premiums: value, low-volatility and quality.
More recently, PKA, a large Danish pension fund, cited the results of the NBIM study as an input into its changes in strategic equity allocation. While not yet fully implemented, it is targeting exposure to a range of equity factor premiums, such as value, momentum and low-volatility.
Obviously, the shift in interest toward factor premiums did not happen overnight. As Blitz explains, it began years ago when academic research began to question the efficiency of market-cap-weighted indexes. “There is a stream of literature that clearly says that market-cap-weighted indexes are not efficient and that other strategies, such as those focused on value and momentum, yield attractive returns,” says Blitz.
Ignoring these premiums has been cited as the reason so many mutual funds fail to outperform benchmarks, leading to the impression that active management is ineffective. “In fact,” notes Blitz, “research by Robeco and others has found that there are certain types of funds that do beat the market. These are the funds that are following systematic factor strategies, such as value and momentum. It is possible to beat the market-cap index using factor premiums.”
Robeco’s own research confirms the importance of factor premiums in equity returns. “Studying the large, liquid portion of the US market since the 1960s, we identified three factor strategies as the most interesting: value, momentum and low-volatility,” says Blitz.
“If you look at returns, you see these factors clearly delivering superior performance over the past fifty years. Not only is there abundant evidence of the strength of these equity premiums in the US market, they are also found in Asian, European and emerging markets as well.”
But this is not really groundbreaking news. The volatility effect was first recognized in the 1970s; value investing has been around for decades--if not longer; and the momentum factor was documented more than 20 years ago. The question has always been how to translate the theoretical returns cited by academics into workable strategies and client net-returns.
As Blitz says, “it’s not a trivial question.” The returns reported in the academic literature from the momentum premium, for example, have tantalized investors for years. It was generally recognized, however, that the returns reported by academics would be hard to realize in practice, owing to high risk and transaction costs.
For this reason, when Robeco set up a research project to examine practical strategic allocations to factor premiums, a very conservative 1% annual return estimate was slotted in for the value, momentum and low-volatility premiums. But even with this conservative estimate, the results show that investors should allocate a sizable portion of their equity portfolio to factor premiums.
Two different allocations were tested. Portfolio 1 took the simpler route, investing 25% in the market-cap weighted index and 25% in each of the three factor premiums of value, momentum and low volatility.
Portfolio 2 looked to maximize risk-adjusted returns, as measured by the Sharpe ratio. Allocations ranging from 30 to 39% were divided between the three factor premiums, with no allocation to the market-cap index. Momentum had the largest share and low-volatility the smallest. The outcome of this research appears below.
“The results were close,” said Blitz describing the returns and characteristics of Portfolios 1 and 2. “Even with a simple approach to factor premium allocation, you manage to capture a lot of the smart beta. But an optimized approach is even better.” Diversifying across the three premiums, he says, also makes sense, because the correlations between the strategies are low.
The “optimized” portfolio resulted in a 28% improvement in the expected Sharpe ratio. The “simple” portfolio also captured a generous improvement in risk-adjusted returns, but was more tilted toward risk reduction than return enhancement.
The historical performance of the two portfolios produced even more dramatic results. The Sharpe ratio basically doubled for both of the factor premium portfolios in comparison with the market-cap-weighted index. This was possible because the actual returns from the historical premiums were much larger than the more conservative 1% per annum return used in the Robeco analysis.
So what’s the big deal? Surely, value and momentum have been played before. Blitz is ready with an answer. “If you look at a traditional quant manager, the objective is to use the strengths of momentum and value investing to do a little bit better than the market. The traditional quant manager starts with the market and tries to get a little bit more return.
“What we are now seeing is the unconstrained application of systematic investing. Where you do not have the limits of a benchmark. That’s the difference.”
His research is not finished. “We are now looking at the optimized portfolio and exploring whether it is possible to do better using dynamic allocation. Value strategies, for example, can sometimes prefer low-risk and sometimes high-risk stocks. We want to know if it is possible to take advantage of the time-varying characteristics of factor premiums.”
A second innovation that is part of the Norway model is moving the allocation to specific factor premiums to the level of a strategic investment decision. Blitz believes it needs to be a top-down call because of the long investment horizon of factor premiums.
“In the late 1990s, value investing massively underperformed versus the market. By the end of the decade, many people thought value investing was dead,” he says. “With manager selection based on relatively short investing periods, underperforming for three years or longer can end a career.
“Because these premiums are optimally realized with long investment horizons, allocating to them cannot be a short-term decision,” emphasizes Blitz. “All the asset owners who fired their value managers missed the enormous recovery in value stocks. The long horizon requires these allocations to be part of the strategic asset allocation process.”
His advice? “Invest in the factor premiums that you most believe in and make it an intentional, well-considered decision. That’s the best way to efficiently harvest the recognized superior returns of factor premiums.”
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