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We talked to Mark Voermans, senior portfolio manager at APG Quantitative Equities and an early proponent of factor investing in the Netherlands.
We asked him to provide some insight into how this type of investing can fulfil pension fund objectives. He is critical towards index-based factor solutions. “When replicating factor indices one cannot take into account all individual investor preferences.” he says. The Dutch asset manager APG is one of the largest pension money investors in the world; it has over EUR 400 billion in assets under management. Quantitative equity strategies are an important component of its investment activities and incorporating ESG is one of its main challenges.
“When replicating factor indices one cannot take into account all individual investor preferences. The type of strategy depends on the type of investor. The specific portfolio you construct for a smaller pension fund will likely differ from one for a large asset owner. In my opinion, there is no one-size-fits-all-index.”
The goals of pension funds go beyond outperformance and risk reduction. There are at least three additional objectives, which cannot be attained by replicating standard indexes. The first is incorporating ESG (environment, social and governance) criteria into the investment strategy.”
“Portfolio turnover is the second consideration. And not just because of the market impact of turnover on net returns. The portfolio should also reflect the long investment horizon of the pension fund.”
“The third reason why the approach to factor investing should be active is capacity. Index-replicating solutions will cause investors to trade at the same time during index rebalances, which might not be optimal. It can be difficult for a large pension fund to trade without affecting the markets.”
There are index providers that make one-size-fits-all index products that can be replicated in a low-cost investment strategy. This suggests that it is relatively easy to earn a factor-premium. But one should not underestimate the complexity of a factor strategy: a wide range of choices has to be made before constructing a portfolio. These choices range from weighting schemes, capacity restrictions, ESG, sector-, country- and stock-size limits to the type of universe, and how to rebalance. Since these choices will impact the risk and returns in the future, the choices a portfolio manager makes should be extensively researched and customized to the needs and goal of a client.”
“A further disadvantage of index solutions is the ten-day advance notice that providers give on changes to the portfolio. This is sensitive information for asset owners, because it can be used to legally front run orders and thus adversely affect returns.”
“Capacity – a strategy that works well on paper may encounter problems when it is implemented. For example, in a backtest you may work on closing prices on the last trading day of the month. But in reality it could take days to execute a stock trade. Making a backtest more realistic makes sense, but you will never be able to mimic reality.”
“There are three main steps from research to implementation. The first is at the factor level – the choice of a factor, based on research and fundamental beliefs, and the choices on how to construct that factor.“
“The second step is at portfolio construction level. Besides the portfolio construction choices discussed before, it is also quite relevant how exposures to factors that were not intended to be in the portfolio are handled. You can neutralize them, but also take them for granted.”
“The third step is implementation, for example, how to handle corporate action events. Other considerations are the use of cash, derivatives and securities lending. All in all, portfolio managers need to make many (client-specific) decisions.”
“In stock selection models ESG used to be implemented by exclusion lists. I believe there should be a shift from exclusion towards inclusion or positive criteria. Many ESG criteria have the potential to be incorporated into stocks election models. These ESG criteria mainly have low risk- and quality-like characteristics.”
“At APG, incorporating ESG criteria into all our quantitative strategies is a clear focus area, which provides a challenge for the next five years. There are two conflicting objectives for which we will have to find a solution: quantitative strategies need a large universe of stocks, but you also have to know every company you invest in from an ESG perspective.”
“A benchmark should be used as performance reference and should reflect investor expectations. The selection of a benchmark should be linked to the factor strategy’s goal. For example, if the goal is to outperform a market-cap weighted index, then a market-cap index can be an appropriate benchmark.”
“Another alternative is to take a factor index for benchmarking purposes. However, these are not representative of a whole factor-category – a value index is just one many possible value strategies. One solution is to construct a peer group of different value indexes, but in general my experience is that it is easier to use the market-cap weighted index as benchmark.”
“I see two major trends evolving. The first is big data. APG has ambitions in this area. There is a huge amount of potentially useful data on the internet, like via social media and blogs. Artificial Intelligence can help dissect this data in such a way that it can be effectively applied to quantitative investment strategies.“
“The second major trend is ESG. Currently, a lot of attention is given to the reduction of the carbon footprint of a portfolio. In contrast to big data, the challenge here is the absence of sufficient data, although I am optimistic that the asset-management industry and academia will incorporate ESG criteria into their research, because more data covering longer periods of time is becoming available.”