Home' Superfunds : Superfunds November 2016 Contents FACTOR INVESTING
The term may be new but many of the concepts
behind it are not. Factor investing seeks to identify
and capture broad, historically persistent drivers of
return. It looks beyond the traditional asset class
labels to identify the true underlying sources of
risk return. We define two types of factors: macro
factors and style factors.
Macro factors capture systematic risks that
cannot be diversified away. Investors are paid a
premium over the long run for bearing these risks.
Research shows that economic growth, real rates
and inflation are the three most important macro
factors. Together, macro factors explain the lion’s
share of asset class returns.
Style factors are observed within asset classes.
Value, momentum, low volatility, and carry are
examples of style factors that are commonly
cited in equities, and also exist in fixed income,
commodities, currencies, and even private
markets such as private equity and real estate.
Style factors help explain the dispersion of security
returns within an asset class. Their predictable
and persistent patterns can be used to generate
returns in both long only strategies (smart beta) or
from a long/short implementation (enhanced style
factor (ESF) strategies).
Macro and style factors are the building blocks
for factor-based investing. Finding the right
mix of assets requires an understanding of the
economics of these underlying factors. With a
better understanding of these return drivers,
investors can build more robust and diversified
ANALYSING A MYSUPER PORTFOLIO
USING A FACTOR LENS
The asset allocation weighting for a typical
Australian MySuper portfolio (using the median
manager strategic asset allocation (SAA) weights
for APRA registered MySuper schemes from data
published on APRA’s website) is illustrated in
While the portfolio may appear to be well
diversified from a capital allocation perspective,
it is not well diversified from a factor perspective.
The portfolio is overwhelmingly exposed to a
single risk factor: economic growth. In fact,
economic risk contributes 691 basis points, or 89
per cent of total portfolio risk.
FOR WHOLESALE CLIENTS USE ONLY – NOT FOR DISTRIBUTION TO RETAIL CLIENTS
[ 8 ] HOW SUPER IS YOUR MYSUPER PORTFOLIO? APPLYING FACTORS TO ENABLE BETTER OUTCOMES
Macro and style factors are the building blocks for factor-based investing. Finding the right mix of
assets requires an understanding of the economics of these underlying factors. With a better
understanding of these return drivers, investors can build more robust and diversified portfolios.
Why are some factors rewarded and others not?
The concepts behind factor investing have been steeped in academic literature for decades. The
oldest and most well-known model of stock returns is the Capital Asset Pricing Model3 (CAPM),
which became a foundation of modern financial theory in the 1960’s. Under the CAPM model,
expected returns of stocks are driven by just one main driver - systematic risk, which is the risk
that arises from the exposure to the market, and this risk cannot be diversified away. The higher
the sensitivity of a stock to the overall market (or the higher the beta), the higher the stock’s
During the 1970s, academics realized that expected returns were driven by more than just the
broad equity market. That is, the equity market alone couldn’t account for all sources of return
– macro factors and styles of investing were also important drivers. The Arbitrage Pricing Theory4
(APT) emerged as a formal theory where multiple factors could affect expected returns.
When it comes to factor investing, perhaps one of the most well-known models in this area was
developed by Eugene Fama and Kenneth French, known as the “Fama-French Model”5. This model
looked to explain US equity market returns with three factors: the “market” (per CAPM above), size
factor (large vs small cap stocks) and the value factor (low vs high book value to market stocks). A
fourth factor, momentum, was later added by Mark Carhart6.
While equity factor research tends to be much more prevalent than that for other asset classes,
many of these characteristics persist across other asset classes as well. Certain factors have
positive expected total returns over the long run, driven by the powerful forces that shape risk
preferences, investor behaviour and market structure. Macro-economic risk factors capture
non-diversifiable risks that have exhibited positive expected returns over longer periods,
compensating investors for bearing those risks.
Returns only consistently positive
for managers with skill
Style risk factors
Have historically delivered return premium
over long term – capturing arisk premium,
behavioural anomaly orstructural
impediment. Can be implemented via
long-only or long/short portfolios
Macro risk factors
Non-diversifiable risks that have
exhibited a positive expected return
over longer periods
u Real rates
u Low volatility
u Country and
u Market and
FIGURE 2: SOURCES OF PORTFOLIO RISK AND RETURN
Source: BlackRock, illustrative example only.
3. Lintner 1965, Mossin 1996, Sharpe 1964 and Treynor 1961
4. Ross, 1976
5. Fama, French 1992
6. Carhart, M. 1997
Source: BlackRock, illustrative example only.
Figure 1: Sources of portfolio risk and return
Superfunds November 2016
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