Treasury Today Country Profiles in association with Citi

Factor investing: rising above cap-weighted benchmarks (part two)

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Factor investing offers scope for more precise portfolio construction. In low return environments, are they a more effective means with which to assess market risk and enhance returns? In part two we look at build, purpose and possibilities.

Building a portfolio

Value, growth and momentum are Invesco’s key factors. These are typically assessed quantitively, using a number of data sources. This suggests experience is essential, not least to compile the data sources and build the analytical tools.

“We have a number of proprietary signals that we use to enable us to draw out certain factors and weight them to certain stocks, constructing portfolios on that basis,” says Dean Heaney, Institutional Sales Director at Invesco.

Fund managers invest heavily in resources to be able to deliver factor investment portfolios. Invesco has a team of over 50 based mainly in its Frankfurt office but also New York, Melbourne and Tokyo. The team includes several PhD-level academics helping to construct the necessary risk and return models. “It’s important to have the expertise and depth of resources not only to monitor and develop existing models but also to be able to construct new ones capable of eking out more performance,” explains Heaney.

New models

Invesco today runs around £25bn in factor-based portfolios. Having been in this space for around 30 years, Heaney says the fixed income territory is now being investigated.

“Our research has focused on creating credit factor definitions consistent with traditional equity factors and applying them to corporate bonds,” comments Heaney. Whilst corporate bonds have traditionally been classified by maturity, rating and industry, the firm has created a four-factor model that includes liquidity, quality, value and momentum.

“Thinking of better ways of constructing a fixed income index will be important going forward because where at the moment we tend to lend to the most indebted companies, we could be looking at credits in a different way.”

An investment strategy that blends equity and fixed income factors, creating a multi-asset, multi-factor portfolio, may indeed be the answer.

Treasury possibilities

Factor investing would typically be for longer-term investments of non-operational cash, says Heaney. Initially, he advises, treasurers considering this approach need to look at their cash flow requirements. “They need to ensure they are comfortable having money in slightly longer-term investments.” There may well be investment policy adjustments to manage.

With full transparency over all holdings, an environmental, social and governance (ESG) angle is entirely possible for investors, says Heaney. Perceived ‘sin stocks’ can easily be replaced by acceptable alternatives with similar characteristics. “The investor may not have to give up any potential return for upholding an ESG policy,” he says.

Is it worth looking at? Whilst a fund manager is involved, “sense-checking” the construction and weightings of each portfolio, holdings are usually only traded monthly, explains Heaney. A highly active fundamental research-driven fund manager could response to market events quicker.

However, as a quantitatively-driven systematic approach that harnesses well-understood and academically proven factor premiums, net-of-fee returns can rise above a cap-weighted benchmark over time. For some, equities are a risk too far. But as factor investing broadens out, their appeal may well see them a fixture on the treasurer’s long-term investment plans.