Factor-investing is a key strategic priority for Northern Trust Asset Management, the Chicago-headquartered asset manager's Head of Quantitative Strategies Michael Hunstad tells AMWatch at the beginning of an hour long interview in Copenhagen.
His overarching argument is intuitive: Many global asset owners are increasingly adopting factor strategies because of their relative consistency and scalability.
"We are seeing more asset owners decrease their number of fundamental active managers and changing to have a few systematic factor-based managers," Hunstad, who has a Ph.D. in applied mathematics from the Illinois Institute of Technology, says to AMWatch.
"This is currently one of the key drivers," he adds.
The quant chief and his 30-person team oversee roughly EUR 28 billion in factor style-based investment strategies globally.
Outperformance among fund managers tends to be due to factor exposures, and to a lesser degree, stock picking abilities.
The lion's share of a portfolio's performance over a 20-year period can be attributed to factor exposures, and very little to true skill, according to the mathematician.
"Outperformance among fund managers tends to be due to factor exposures, and to a lesser degree, stock picking abilities. This is one of the reasons many clients are moving in the multi-factor direction, thus harvesting the equity risk premia across various cycles," he says.
The reason investors tend to get paid, or earn excess returns, from factors is compensation for bearing risk through cycles. This means that any investors with a long holding period have time diversification on their side and can withstand a lot of these factor cycles. In 2018 and 2019, however, many of the systematic investment strategies fell short of the market.
"The challenge with the returns over the past 18 months is that all factors can and do go through cycles, meaning periods of underperformance typically followed by periods of outperformance, which is something we constantly educate our clients about," he says, emphasizing that factor-based strategies are not the right application for investors with a time frame of less than five years.
Standing out in a crowded market
As more capital flows into these strategies, more asset managers are developing their own solutions to meet the growing demand. In the Nordics, the popularity of factor-style investing has grown considerably over the last few years and the investment approach is widely used among both asset managers and pension funds.
As an example, Denmark's ATP overhauled its investment portfolio in 2015, resulting in a factor-based approach under the watch of CIO Kasper Ahrent Lorenzen, who has since moved to PFA.
For asset managers wanting to beef up their quantitative solutions, such as what Danske Bank is currently doing, there are essentially three ways to stand out from the crowd: factor definitions, costs and portfolio construction.
Hunstad emphasizes that it is important to have a multi-dimensional approach when defining the various factors and not only look at one static metric, for instance using the price to book ratio as a metric for value.
"We have been using our own approach for more than 25 years, which has been good at extracting the value risk premia," he explains. "We use a variety of metrics of our own design. A lot of factor definitions are prefabricated from accounting statements and there are, for instance, differences in how accounting statements are prepared across the world," he says.
In the past, a lot of multi-factor strategies tended to be weighted by a notional value. This means 25 percent momentum, 25 percent size, 25 percent value and 25 percent low volatility as an example. However, momentum tends to have a lot of volatility associated as it is a risky factor. The opposite counts for low volatility.
One approach in relation to portfolio construction is to be dynamic and try to shift between factor exposures. According to Hunstad, the dynamic approach tends to be incredibly challenging because investors need to know not only what the leading indicator of a factor's performance is but also when the factor will start to outperform.
"We find that it is very difficult to actually add value consistently through a timing approach," he emphasizes. Instead of trying to time the various styles in the market, the team prefers to create multi-factor strategies that have fixed weights. These weights are defined by their contribution to risk.
"In our multi-factor portfolios, momentum gets less allocation than 25 percent notional allocation because it tends to have a lot of active risk associated with it," he explains.
"In the past, a lot of multi-factor strategies tended to be weighted by a notional value. This means 25 percent momentum, 25 percent size, 25 percent value and 25 percent low volatility as an example. However, momentum tends to have a lot of volatility associated with it, as it is a risky factor. The opposite is true of low volatility.”
An investor might cultivate a portfolio that looks like it has an equal weight across all factors on the surface, but is dominated by one or two factors from a risk perspective.
"The big challenge is that if they are not sector and region neutral, they will tend to have very large exposures to certain countries and sectors. That source of active risk then dominates the portfolio," Hunstad says, adding that this is a common issue for investors across the world, leading them to take unintended sector bets in their investment portfolios.
As an example, fluctuating oil prices can make stocks in the energy sector look temporarily cheap. Consequently, naïve value strategies may load up on these energy stocks, exposing the portfolio to a high degree of commodity price risk.
"This is a risk value investors may not have intended or desired," the Ph.D. says, adding that a low-volatility strategy could easily lead to a significant overweight in utilities, consumer staples and real estate if not controlled.
"Those sectors are defensive sectors but they carry lot of active risk. They happen to be the bond proxy sectors, and there is a lot of interest rate sensitivity associated with those sectors," he says.
Another thing Hunstad notes is the changing correlation between the various factors. "A few years ago there was a high correlation between low volatility and momentum. Now that has gone down significantly. But the challenges are that as these correlations change - and they always do – so do the consistent factor exposures," he says, adding:
"What we see is that many multi-factor strategies have bled out a lot of their factor content because of changing correlations. If value and momentum become negatively correlated all the sudden you start to reduce either momentum or value, or in worst case both."
The underlying reason for a lot of the factor anomalies is behavioral. Market participants behave differently, which goes against the assumptions of a lot of traditional asset pricing models.
"The CAPM (capital asset pricing model, ed.) says all investors are exactly the same with the same risk preferences and constraints. However, nothing could be further from the truth than the CAPM assumptions - investors have different time frames, objectives and constraints," Hunstad says.
For example, investors tend to have little access to leverage which can explain the low volatility phenomenon. Investors tend to bid up the price for higher beta - higher volatility stocks to the point where lower volatility tends to do much better.
"Are we going to arbitrage those anomalies away?" Hunstad asks rhetorically. "Absolutely not, because when you are an arbitrager or algorithmic trader what you do is look at mispricing between markets. No matter how many hedge funds or long only strategies are in the market, you are not going to change the behavior of the underlying investors.”
Hunstad draws a correlation with the equity premium. "For the hundreds of years we have had equity markets, we have seen more than USD 70 trillion moving into equities but we have not exhausted the equity risk premium," he concludes.
The newest strategy under his watch, entitled the Northern Trust Emerging Markets Quality Low Carbon, was launched in January 2019 and aims to tackle the climate disaster risk while enhancing performance through the integration of Northern Trust Asset Management’s proprietary quality factor. The style factor targets companies that are efficiently managed, profitable, and have strong cash flows.