Something to Factor in

20 November 2019

By Ronan Kearney, Investment Manager HC Verbatim Multi-Index Funds

Investors have historically allocated capital mainly by asset class, gaining diversification through exposure to equity funds, bonds and other asset classes. However, in times of market weakness, different asset classes can re-correlate, thereby removing the diversification benefits of investing with an asset-class approach. According to a paper by the Reserve Bank of Australia, the correlations between stock and bond yields turned positive in the late 1990s and the two asset classes have been highly correlated since – particularly so in the wake of the global financial crisis.

More investors are turning to the underlying performance drivers inherent in many assets and are allocating capital to factors rather than by asset class. Common equity factors include value (undervalued stocks tend to outperform expensive ones), low volatility and small cap, amongst an increasing number of other identified drivers of return. A factor is any characteristic shared by a group of stocks that can explain their returns and risk. There are a number of different factors that are well researched and have been shown to have attractive risk and return qualities.

  • Value Factor - Equities that have low prices compared to their fundamental value
  • Size Factor - Equities with smaller market capitalisations
  • Momentum Factor - Equities with higher price momentum
  • Low Volatility Factor - Equities with lower volatility (Beta)
  • Quality Factor - Equities with low debt, stable earnings, and other quality metrics.

When it comes to portfolio construction, the debate of asset allocation versus factor investing is ongoing.  Those who choose to build portfolios from asset classes argue that they are easy to observe and are easily investible. Investors who prefer to allocate to factors argue that asset classes are defined arbitrarily and do not capture the fundamental determinants of performance as effectively as factors do.

By constructing a portfolio that includes exposure to multiple factors, many of which have low correlations to one another, investors aim to achieve more balanced and diversified funds than would otherwise be the case. Long-only smart beta strategies build indices that have a tilt to one or more factors. These funds, sometimes called custom indices, can either re-weight standard benchmark indices or construct new indices from scratch. For example, a smart beta strategy could involve assigning alternative weightings to the constituents of the FTSE 350 benchmark index, in order to reduce the bias towards large stocks and offer a tilt towards Quality shares.

On the other hand, an index could be assembled from scratch after identifying a basket of value stocks and investing in those which meet the strategy’s rules and criteria. This requires analyses and decision making and applies active fund management to passive investing.

At Verbatim, we have developed an approach that allows investors to get the best of both worlds. By integrating asset allocation and factor investing, thoughout the HC Verbatim Multi-Index portfolios, we can preserve the benefit of investing in observable and directly accessible asset classes, while capturing our preferred factor exposures. We have achieved this by working with the FTSE and Hymans Robertson to create proprietary factor-based benchmarks in key asset classes.

In a recent research paper (Martellini and Milhau 2018) it can be seen that there are two main types of benefits that can be expected from factor investing. On the one hand, factor investing across asset classes allows for better management of the investment process, in both a growth perspective and from an asset-liability management perspective (drawdown). In addition, factor investing within asset classes allows for potentially better returns when compared to traditional approaches that focus on traditional sectors.

The comprehensive risk allocation framework designed by Hymans Robertson and the SimpyBiz Investment Services Investment Committee, has been used by Verbatim throughout the HC Verbatim Multi-Index portfolios, to develop the factor investing process across and within asset classes in a coherent manner. The framework involves two steps. First, the combined use of effective factors that look to exploit sectoral differences in risk and return parameters, as well as the macro-economic factors that influence changes over time and allows Verbatim to implement efficient allocation decisions. Second, when the allocation decisions are translated back into more traditional asset class decompositions, the use of Verbatim’s smart factor indices as building blocks allows the potential for greater investment returns.

In conclusion, a healthy balance between the major risk factors is necessary for an overall portfolio to be meaningfully diversified, and thanks to the work that Verbatim has done in the last 18 months, factors are becoming more widely available for use by advisers.

 

The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.