Mo Haghbin: People use various monikers, such as low volatility, defensive equities, min-variance, etc.
Generally speaking, with these types of strategies you are looking at the lowest decile or quintile of a particular universe, such as the S&P 500 or Russell 1000, and building up with a rules-based methodology.
"One of the nice aspects is that it is very flexible and relatively
easy to weave into an active management strategy."
The factor that most people look for is a trailing 12-month or 5 year realised volatility figure, while others may use an optimiser with various constraints.
Typically, if it is done correctly, it should give you a certain return distribution, which allows you to participate on the upside while protecting on the downside. One of the nice aspects of this is that it is very flexible and relatively easy to weave into an active management strategy.
Mo: From the client perspective, we have seen significant adoption of minimum volatility strategies over the past 10 years.
This was accelerated post-Financial Crisis, and more recently, with more retail investors having access through ETF products.
Last year, more defensive strategies, such as minimum volatility and quality, were favoured by investors, particularly in the fourth quarter when volatility spiked.
"Although we have been in a risk-on environment, investors
are still pretty defensive with their equity allocations."
We also saw flows into multi-factor approaches with dynamic or rotation strategies also gaining traction.
Year-to-date, it is a little bit of the same story. Although we have been in a risk-on environment, investors are still pretty defensive with their equity allocations.
Fixed income ETF flows made up about 55% of all flows into the US listed ETF market. And when you look at regional allocations, investors still favour US equities over international emerging market equities.
Mo: If we look at what has happened over the past several years, flows into single factor strategies have been extremely strong.
But more recently, we have seen multi-factor approaches becoming more popular with investors, and there is a very good case for this.
Investors are starting to accept the fact that they need diversification across their factor portfolios as much as they need diversification across asset classes, sectors or regions.
One of the areas we have been working on over the past two years with FTSE Russell, has been the research around factor cyclicality and understanding the nature of factor returns through time.
This is consistent with first taking a look at your portfolio risk relative to your benchmark. When thinking through a factor lens, you should understand which factors you are overweight or underweight, and then determine whether this is consistent with your philosophy or views.
If it isn’t, then perhaps you would use single factor strategies to correct some of these biases within the portfolio.
On the other hand, if you are looking for a core-equity solution, one of the things we have recognized is that focusing on single factor strategies tends to produce a portfolio that is exposed to some of the macro factors that don’t necessarily reward investors at all times.
We have been thinking about factor strategies using the macro environment to make determinations around which factors to overweight or underweight.
This is somewhat of a controversial topic within the marketplace right now, but we find there is an ability to add value with modest tilts using macroeconomic information when deciding factor allocations.
Mo: The strategy started within the institutional space. This was something that institutions had been considering for many years. With the availability of products and tools, third-party or otherwise, that allow you to take a look at factor exposures within your portfolio, we have seen more mainstream adoption of these types of approaches.
I spend quite a lot of my time now speaking with financial advisers around their factor exposures and how to position portfolios to be more consistent with their philosophy.
We have gone as far as to say that when you are thinking about your risk allocation, the traditional way of doing this doesn’t make sense anymore. Rather than thinking in terms of sectors or regions, factor exposures are the primary drivers of risk and return of a portfolio.
"When you are thinking about your risk allocation, the traditional
way of doing this doesn’t make sense anymore."
Generally, when we think about exposures to the market, we are using indices that are market cap weighted, and bond indices that are issuance weighted.
There are certain factors that impact what you own if you use these as your benchmark. For example, you may have an over concentration of interest rate risk in standard bond indices as a result of many years of Quantitative Easing (QE).
Today, your standard aggregate bond index has 90 per cent of the risk coming from interest rates, and only 10 per cent coming from credit. In the past, there was more balance.
Similarly, with market cap weighted equity strategies, you get a structural momentum bet. You tend to own more of something as security prices run up.
But if there is a momentum crash, you are impacted by this more heavily because you have essentially overbought the winners over time.
Understanding these dynamics when you are thinking about portfolio construction can be very helpful. There isn’t necessarily a right or wrong way, but rather an understanding of what you own.
Mo: From a theoretical standpoint, cap weighting does make sense, because you get an aggregate view of the market when it comes to the value of a security. It is a good starting point, but it isn’t the only way that you can think about ownership of a basket of stocks or bonds.
Alternative methodologies have tended to focus on factor-based approaches or fundamental indexation.
Although this isn’t a new strategy, in times where you see market cap weighted strategies underperform, you tend to see fundamental indexation outperform. This is because it tends to tie the ownership of individual stocks to a fundamental, such as revenue, earnings or cashflows. This is probably more closely aligned with how an active manager thinks about ownership.
