Forget asset allocation, it's all risk

Facing the prospect of an extended low-return environment, increasing numbers of asset owners are refocusing their portfolios on risk factors, rather than asset allocation.

Institutional assets invested using MSCI Inc.'s factor-based indexes totaled $123 billion as of March 31, up 29% from a year earlier.

Industrywide investment in factor-indexed approaches was an estimated $400 billion to $500 billion as of March 31. That's up from $100 billion to $150 billion as of the same date in 2013 and $10 billion to $15 billion in 2011, MSCI estimated.

Assets in risk-factor investing might be only a drop in the bucket compared to total global institutional assets. But total assets invested using the approach - a significant proportion of which is from institutions — increased more than 30-fold in the five years ended March 31, noted Brett Hammond, MSCI's managing director and head of fixed income and multiasset applied research, based in New York.

Factor-based investing assumes that risk premiums — the return resulting from holding assets that carry risk — can be identified by a wide array of factors beyond simple equity market risk.

Once identified, investment managers capture those risk premiums systematically through passive factor-based replication strategies or through portfolio construction based on a combination of risk factors.

Often termed smart beta by marketers, the investment approach combines market beta and alternative risk premiums culled from a wide range of risk factors, including value, size, momentum, value, low volatility and quality.

Consultants said a large and growing group of quantitative, passive, hedge fund and other alternative investment managers have jumped into factor-based investing or are significantly beefing up their capabilities because of growing client demand.

Laurence D. Fink, chairman and CEO, BlackRock Inc., New York, for example, said in an April 16 earnings call that his firm has seen increased interest among institutional and retail clients for factor- or model-based investing.

“We've had more dialogue on our model-based, factor-based products (now) than we've had in five years,” said Mr. Fink on the call.

“This is an area I believe is finally going to see accelerated growth.” (BlackRock on April 30 announced the launch of five factor-based exchange-traded funds through its iShares division.)

BlackRock managed $4.774 trillion as of March 31. Of that, $129 billion was managed in smart beta strategies.

Institutional investors are reapproaching the quantitative space through smart beta, said Fabio Cecutto, senior investment consultant-manager research, Towers Watson & Co., New York.

To date, it has been mostly large public pension plans and sovereign wealth funds that have applied the tenets of risk factor-based investing across their equity portfolios.

For the rest of the industry, “it is early innings for investment, middle innings for factor-based research, and a time of intense self-reflection,” said Adam Duncan, senior investment director at investment consultant Cambridge Associates LLC, Boston.

Many institutional investors are in the early stages of reviewing factor-based investment strategies and most start with a “super useful exercise of self-inspection” of decomposing their existing portfolios to see what risk factors it is already exposed to and where the risks lie, Mr. Duncan said.

“Understanding what drives returns — interest rate risk, inflation risk, economic risk, for example — is what institutional investors are investigating now as they try to find a way to deliver a tall order in their portfolios: less equity risk, low correlation and drawdown protection,” said San Francisco-based Kevin Kneafsey, senior adviser of multiasset investment and portfolio solutions, Schroder Investment Management Ltd.

“Asset allocation categories are messy and nonsensical,” Mr. Kneafsey said, noting that moving away from an asset allocation approach requires that “you start by taking apart each asset class and reorganizing the portfolio by factor drivers.”

Schroder managed $468 billion as of Dec. 31, of which $122 billion was managed in risk factor strategies.

“The real revelation is that asset allocation isn't the "thing.' Risk premia are the `things,'” said Cambridge's Mr. Duncan.

What's drawing investors' attention and benefiting quantitative and other investment managers is that factor-based investing is a hybrid approach that replaces active management.

“Markets have clued in to the fact that active stock picking is not an efficient, persistent way to generate returns. The writing is on the wall for active management. The most sophisticated money is moving this way,” said Michael R. Hunstad, senior vice president and director of quantitative research, Northern Trust Asset Management, Chicago.

Northern Trust managed a total of $960 billion as of March 31, of which $9.8 billion was in factor-based approaches.

The advantage of “evolving a portfolio from active management to a more systematic approach is that it is more cost-effective and more transparent,” said Ronen Israel, principal at AQR Capital Management LLC, Greenwich, Conn.

AQR managed a total of $132 billion as of March 31, of which $7 billion was managed in long/short multiasset and multistyle factor-based strategies and $10 billion was managed in long-only multistyle or single style sleeves.

“If you think about the firms who have had early success in smart beta, who are talking about things like managed volatility (and) momentum investing, many times the tools and ways quantitative investors think aligns nicely with a lot of those investor demands,” said Justin R. White, a partner with money manager consultant Casey Quirk & Associates LLC, Darien, Conn.

Not everyone in the investment industry is enamored of factor-based investing in general and some implementation models in particular.

“Whenever Wall Street is pushing a hot new topic or product, it's a time for `buyer beware,'” said Matthew K. Maleri, partner-asset allocation, at investment consultant Rocaton Investment Advisors LLC, Norwalk, Conn.

Factor-based investing styles that try to capture risk premiums “is just repackaging risks that investors already own through their equities holdings. Investors already have these exposures,” Mr. Maleri said.

AQR's Mr. Israel noted that the theses behind risk-factor investing are “well-understood, the problem is that the implementation of a systematic investment approach to capturing risk premia takes a very high level of skill and craftsmanship. These are not idiosyncratic ideas, but the capture of them is not all that easy.”

“There's a lot of product being developed out there and not all of it is good,” said Cambridge's Mr. Duncan.

Mr. Israel and other sources agreed that consolidation among the money managers providing factor-based investment strategies is likely, and will come as more skilled managers differentiate themselves by their returns and risk management processes. n