Long-horizon investors can withstand macro-economic volatility and so should tilt towards strategies that are exposed to that, including value, small cap and momentum. Oleg Ruban, vice president in the applied research team at MSCI says this validates factor-investing and factor-based asset allocation for these investors.
Appropriate asset allocation requires explicit attention be paid to the different problems, risks, horizons and constraints of different investors. It’s part of the evolution of modern asset allocation which has moved from equal weighting, risk weighting and risk parity through mean-variance and Black-Litterman reverse optimisation through to a more modern dynamic approach that includes looking at tolerance for macro-economic risk.
Unlike a more traditional approach which says most investors should invest in a similar way, outcome-oriented investing says the way to build a portfolio is to blend the components.
“You start with a market portfolio, and tilt away from the market depending on the different horizons and risks of the investors. The tilts can come from factors, pure alpha or skill and from risk hedging,” Ruban, who focuses on portfolio management and risk related research for asset owners and managers, says.
The commonality among institutional investors is they have a long horizon relative to the average investor which alters their risk tolerance.
Ruban expands that to explore the notion of risk versus uncertainty, and differentiates risk as being inherent in a current opportunity set and uncertainty being how that evolves over time.
“This uncertainty relates to macro economic risk and gives us the idea that long-run horizon investors are more tolerant of macro economic shocks because their time horizon means they have an ability to withstand these.”
From an asset allocation point of view, Ruban says this leads to whether there are strategies naturally more exposed to macro-economic fluctuations versus those that hedge those fluctuations.
“Institutional investors should tilt to those more exposed to fluctuations. A lot of traditional quant factors like value and small cap, and some behavioural strategies like momentum have greater sensitivity to fluctuations in economic growth versus the broad market. This leads to the idea long-horizon investors would want to tilt more to these risk premia strategies than short-horizon investors.”
This in turn, validates the idea of factor investing and factor-based asset allocation.
At the end of last year MSCI conducted a global asset owner survey which asked investors about their asset allocation practices and factor investing.
“The majority of participants believe factor investing can capture alpha,” Ruban says. “Ideologically there was an appreciation for factor-based asset allocation but people were still struggling with implementation.”
Ruban says there have been large institutional investors such as the Norwegian Sovereign Wealth Fund, CalPERS and Alaska Permanent Fund adopting factor-based asset allocation and he sees the trend continuing.
“More investors will follow. While there are some operational difficulties in implementation, the trend will continue,” he says.
Identifying the factors to use in asset allocation is part art and part science, he says, noting that organisational considerations play a role.
For example Alaska has identified “companies” as one of its factors and includes in this equities, private equity and corporate debt.
“There is some logic in that there is commonality but there is also some evidence that corporate debt behaves differently to equities at certain times. There is a statistical aspect to factor investing but it is also driven by certain organisational beliefs.”
Ruban says one of the main obstacles to more investors adopting factor-based asset allocation is the need to access the right technology in order to decompose the portfolio and view it through a factor lens.
“The main advantage of doing this is it gives you more detailed insight into what’s driving your portfolio,” he says. “In times of uncertainty factor-based behaviour can be more intuitive than asset class behaviour.”
The MSCI asset owner survey revealed an average asset allocation to listed equities of 38 per cent, but a risk contribution from equities of 92 per cent.
“Equities is more volatile and correlated so the risk contribution is quite high. But this doesn’t tell you much about the underlying structure of these risks, or factors you are exposed to and whether you believe in them or not.”
Factor-based asset allocation allows you to act at a more granular level.
Ruban says there have been some secular trends since the GFC, including investors in South East Asia changing the structure of their portfolios to be more international and investors in Japan adding more risk.
“Acess to factor-exposure analysis informs these decisions.”