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Factor-Based Investing Is on the Upswing

Multiple Authors | 12/10/2016
Factor based

Summary

Long before “smart-beta” and style indices became popular, decades of research proved that risk premiums exist in the equity markets. But Dr Henne and Dr Teloeken warn that using passive products naïvely can create serious risk-management challenges.

Key takeaways
  • Decades worth of highly regarded academic research have repeatedly proved the existence of investment factors
  • A 2009 report found that about 2/3 of the Norwegian Pension Fund’s excess return could be explained by factors and risk premiums
  • This report changed the NPF’s core policy and led to a plethora of new “smart-beta” indices, factor indices and style indices
  • Serious risk-management have arisen as investors moved into passive factor-based products
  • Unlike passive approaches, active portfolio managers can change their portfolios as they seek to capture risk premiums in an efficient, diversified way

A growing number of investors are realizing just how important investment “factors” such as value and momentum are to portfolio performance. This is leading to a wholesale change in how they invest, with many taking back control over their implicit factor exposures by explicitly allocating to those factors.

This shift happened on the heels of several decades worth of highly regarded academic research that repeatedly proved the existence of investment factors – research that hit the mainstream in 2013, when Eugene Fama received the Nobel Prize in Economics for his explanation of the empirical outperformance of value and small caps as risk premiums.

Yet despite this long history of academic research, it took an institutional investor’s investigation of the role of factors in their aggregate portfolio’s performance to permanently change many investors’ minds.

The case of the Norwegian Pension Fund

During the Great Financial Crisis of 2008, the Norwegian Pension Fund – one of the largest sovereign wealth funds in the world – hit a significant and sudden period of underperformance versus its benchmarks. The ensuing public pressure triggered a careful analysis of what had gone wrong.

Part of this analysis came in a 2009 report by renowned finance professors Andrew Ang, William Goetzmann and Stephen Schaefer, who found that despite the fund’s commitment to active investing for its individual mandates, its return behavior was not driven by stock picking; its different investment weights tended to cancel each other out at the aggregate portfolio level. Moreover, the professors proved that about two-thirds of the fund’s excess return could be explained by including well-known factors and style risk premiums – in particular value, size, momentum and volatility. Given the size of the fund, this situation was unavoidable: The role of factor exposures will always be much greater than the role of stock picking.

As a result, the Norwegian Pension Fund decided to change central parts of its investment policy. Although the fund did not move to a completely factor-based approach, it did include key tenets of factor investing in its official “Investment Beliefs”.

The birth of “smart beta”

This report not only changed the Norwegian Pension Fund’s core policy, but it was a seminal moment for the industry and triggered a great deal of interest in factor investing. In response, index providers launched a plethora of “smart-beta” indices, factor indices and style indices. Although these terms largely overlap, they all essentially refer to the same thing: capturing the risk premiums associated with different investment factors.

The issue with passively investing in factors

While we are encouraged by the widespread acknowledgement of the benefits of factor investing, serious issues have arisen as investors moved into passive factor-based products. Imagine, for example, that you are an investor in a basket of prefabricated smart-beta ETFs and you observe that there is a high overlap between your indexes, or that they are all biased towards low-beta stocks or another macro risk. What can you do about it? Not much, unfortunately. Whichever way you weight these indexes in your basket, you will always end up with a high overlap of the investment styles, and hence find yourself stuck with macro biases. This can create a serious risk-management challenge.

The benefits of actively harvesting risk premiums

Active portfolio managers, however, have several options for changing the composition of their portfolios as they seek to capture risk premiums in an efficient, diversified way:

  • Active managers can buy stocks with different factors to get the desired exposures to the right investment styles, but at the same time ensure that the overlap of these investment styles does not become too big.
  • Active managers can buy low-beta and high-beta names. In this way, they can establish the exposure to the desired risk factors, while at the same time spreading out the portfolio in many more risk dimensions to make it more stable than a basket of smart-beta indexes.

Our view

Investors have become increasingly aware of risk premiums in the equity markets – a view supported by decades of research from leading academics. And although some investors may disagree about the number or causes of risk premiums, certain economically significant and persistent investment factors have been identified as reliable sources of risk-adjusted excess returns. At the same time, capitalizing on multiple factors in a portfolio is a difficult task, which is why turning to commoditized smart-beta exposure using ETFs may lead to insufficient risk management. Unfortunately, many ETFs get used naïvely in portfolios, which can invite a range of unintended consequences in terms of macro-economic exposures. An active approach that diversifies those risks may be much more helpful.

This article was adapted from a new white paper, "Factor Investing: A Reliable Source of Excess Returns?". Download the full version.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This material does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This material is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

© 2016 Allianz Global Investors. All rights reserved.

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Benedikt Henne

Co-CIO Systematic Equity
Benedikt Henne is Co-CIO Systematic Equity with Allianz Global Investors, which he joined in 1998. He previously managed equity-enhanced products for the firm. Benedikt has a master’s degree in mathematics from the University Pierre et Marie Curie in France, and a doctorate from the University of Bonn in Germany. He is a CFA charterholder..
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Klaus Teloeken

Co-CIO Systematic Equity
Klaus Teloeken is the Co-CIO of the Systematic Equity team. He joined Allianz Global Investors in 1996 as a quantitative analyst, and in 2001 he assumed the role as Head of Systematic Equity. He is responsible for the team’s development and the management of active investment strategies. Klaus is also the author of several publications on probability theory and statistics, as well as performance measurement and investing. He studied mathematics and computer science, and has a master’s degree and a doctorate from the University of Dortmund, Germany.

Negative Rates Are Forcing Insurers to Adapt

Markus Engels | 18/10/2016
Negative Rates Are Forcing Insurers to Adapt

Summary

Insurance companies are among the many institutions that need to navigate today’s strange world of ultra-low and even negative interest rates. Senior Research Analyst Markus Engels uncovers two kinds of companies that may have found successful formulas.

Key takeaways                   
  • Life insurance companies are steering sales toward risk products centred around mortality or morbidity risk
  • P&C insurers face NIRP headwinds, but they can also reprice their businesses on an annual basis – a product advantage over life companies
  • We look for short-duration P&C and life companies with risk business models that also offer good asset and liability matching

Legendary investor Warren Buffett has time and again sung the praises of the “float” in the insurance companies he owns. As many investors know, the float is the amount that can be invested after insurance premiums are collected but before claims payments are made – and it is a concept that lies at the very heart of his celebrated business model’s success.

But today, Buffett’s insurance companies and many other financial institutions are navigating a strange new environment: a world of ultra-low yields and negative interest-rate policies (NIRP). In this landscape, risk-free interest rates are negative and spreads are artificially kept low – and assets like the float are becoming the new liabilities for many insurers.

Our European Financials research team has been keeping a close eye on the challenges insurance companies are facing from NIRP, and we have noted several new trends.

NIRP is redirecting life insurers toward new products

For life insurers that sell products carrying return guarantees that are hard to fulfill with new investments, NIRP can cause problems if the durations of assets and liabilities are not matched. Life insurers in Japan, Taiwan and Korea have already experienced the long-lasting effects of such a mismatch. That is why today, life insurance companies have been trying to steer their sales more toward risk products centred around mortality or morbidity risk. These products carry fewer assets, and thus their smaller float reduces the asset-side risk substantially.

There have been other new NIRP-related product developments, including new savings products that carry minimal or no guarantees, which make them less capital-intensive. But because of the long durations of this book of business, it will take time before these new products begin to add to these companies’ bottom lines.

P&C insurers seem better positioned to navigate NIRP

While property and casualty insurers are also facing headwinds from NIRP, they are typically able to reprice their businesses on an annual basis – a product advantage that enables them to reflect the latest interest-rate environments in their pricing assumptions. P&C firms also tend to rely less on the float for their profits; instead, they make the lion’s share from the technical profit gained from underwriting risks such as natural catastrophes or accidents. These underwriting profits also bring an additional benefit to P&C companies: They nicely diversify portfolios against the ups and downs of the economic cycle.

Finding the sweet spot among P&C and life companies

In this NIRP environment, Allianz Global Investors has a preference for short-duration P&C and life insurance companies with risk business models that also offer good asset and liability matching. Both types of business are rather capital-light and can be found within reinsurance or selective composite insurers. Not only do we believe firms like these are among those best-positioned to succeed in today’s challenging interest-rate environment, but with sustainable dividend yields that can surpass five per cent, they can also offer investors attractive income potential at a time when other yield sources are woefully insufficient.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This material does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This material is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

© 2016 Allianz Global Investors. All rights reserved.

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Markus Engels

Senior Research Analyst, European Financials
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