For the past few years factor investing has had significant focus from both retail and institutional investors alike. Igniting interest further is a progressive shift from active management to passive management strategies focused on specific market segments or factors, value factor being a prime example.
The factor approach has had limited integration into the investment processes of insurance companies when compared with other institutional or retail investors.
Defining the factor investment tool
Factor investing theory has been evolving since the 1970s. Initially it was defined as a common characteristic across securities which when combined with other characteristics explains the co-movement of the group of securities. We add to that an additional requirement that the list of characteristics must lead to security groupings with as little return correlation between groupings as possible.
Standalone funds created using this factor-based investment framework have the benefit of providing optimal risk adjusted returns through a higher level of diversification. However, for an insurer, further advantages can be achieved by designing a factor investing strategy which also minimises correlations with traditional asset classes in the Strategic Asset Allocation (SAA) and therefore reduces total volatility of the portfolio.
The guide posts are shifting
Globally over the past year, we have encountered a tidal wave of market-threatening events. Changes in monetary policy, international trade agreements and regulatory reform are just some of the uncertainties that can potentially lead to significant turbulence in the near future.
Parallel to these developing uncertainties, the hunt for return has never been stronger; insurers are gravitating towards new asset classes and investment in foreign countries.
For insurers especially, setting a SAA is the central part of their investment framework. Having a robust process that incorporates sophisticated financial modelling and stress testing has become crucial as insurance regulations advance and the range of investment tools expands.
The SAA can be sensitive to many assumptions, but the most important, namely the volatility of asset classes and the correlation between them has had the most significant change in the past few years. The benchmarks or guide posts that are imperative to setting assumptions for the SAA are shifting and our portfolios require careful assessment to avoid being caught on the wrong side of the shift.
Take for example BREXIT, the UK referendum vote to leave the European Union which could have significant consequences ranging from labour laws to international trade. Once the results were announced, global equity markets ended the week with only moderate losses, while the effect on the pound was much more significant, falling nearly 10% over the following week and nearly 18% over the course of the next four months post referendum.
More importantly, the correlation between two of the major currencies in focus, namely GBP vs JPY and EUR vs JPY, changed by over 20% and constituted the most significant shift in currency dynamics in decades.
Switching to other major asset class benchmarks for Asian insurers, Figure 1 shows clear indications of the shift in the dynamics of our guide posts. This is exhibited by a clear uptrend of correlations between Asia Emerging Market and the US/European markets respectively.
The correlations reached a historical high during the 2008 financial crisis (2007-2009) and then dropped but never reached levels exhibited before the financial crisis. In recent years, the up and down shifts in correlations have become more frequent and significant; pushing the average up and reaching for new highs.
What this means is that the guide posts used to set assumptions are shifting in a way that make the SAA sub-optimal but also shifting frequently enough that the extent to which the SAA is sub-optimal is also uncertain a priori.
Positioning our portfolios today to maximise diversification and leverage uncorrelated return opportunities is imperative as the dynamics of the market shift.
Factor investing to hedge the uncertainty
In order to mitigate these shifts in the fundamental building blocks of an insurer’s SAA, we turn to factor investing which by design can potentially provide stable volatility, with low correlated returns that effectively balance out the market shifts that would otherwise make the SAA less effective.
Figure 2 shows the volatility of the S&P 500 together with some of its traditional sub-sector and factor components. The key difference in how these sub-sector indices and factor indices are constructed is simply in their objective.
Whereas the sector indices are constructed to include all stocks whose underlying companies have operations in those sectors, the factor indices construction has the objective of designing groupings of stocks in order to generate uncorrelated returns. As a result, the underlying stock selection is of lesser priority for the factor indices and is to some degree, a means to an end.
Figure 2 shows that the volatility of the factors on average are much lower than the traditional market sub-sectors. Moving on to the correlation on Figure 3, we also see that on average the correlations are closer to zero.
The dispersion of correlation can be further mitigated through a multi-factor approach that dynamically re-weights the factors in order to optimise the correlation structure. This is optimally done in conjunction with the SAA with the objective of minimising the overall volatility of the portfolio.
How a dynamic multi-factor approach fits into the portfolio
The true benefit in factor investing comes from its integration with the SAA in the form of a multi-factor overlay. Insurers have well established methodologies utilising traditional approaches to portfolio construction, focused on achieving their high level company objectives. Factor investing can be utilised as an overlay that concentrates on smoothing out some of the market turbulence we described above and ultimately buffering the SAA so that it can achieve the original objectives.
In the case study, we focus on optimising the US equity portion (10% of total portfolio) in order to minimise total portfolio volatility. Figure 4 shows the volatility contribution between an insurance portfolio with and without a factor fund overlay. The overall volatility of the total portfolio falls by 20% when we add the factor overlay, which is due to 1) the lower volatility contribution from the US equity plus factor overlay and 2) the lower correlation with the rest of the portfolio.
In Figure 5, we show the backtested performance of the US equity portion of the portfolio with and without the factor overlay.
Factor investing can balance the Strategic Asset Allocation through the shifting markets
Falling returns of traditional asset classes, volatile markets, enhanced regulatory scrutiny and political “surprises” creates a challenging investment environment for all institutional investors. But as always, a well-diversified investment framework aligned with the long term enterprise objectives is key.
Factor solutions serve as a powerful tool which because of their low correlation nature can provide an enhanced risk adjusted return. Through an integrated application of multi-factor solutions in an insurer’s portfolio, we utilise the full potential of this investment class as a volatility reserve that allows the SAA to function optimally, maximising the portfolio’s ability to support the high level company objectives that can be achieved.
Mr Paul Sandhu is Head of Investment Solutions at Conning Asia Pacific Limited.