One courageous pension fund is letting its members put their money where their mouth is. The Pensioenfonds Detailhandel has surveyed its members about their sustainability preferences and is actually making investment decisions based on the results of the survey.

In June 2018, active members of the €23 billion fund for retail workers in the Netherlands were invited to participate in an online survey run by academics at Maastricht University. Respondents were asked to decide on the sustainable investment strategy of their pension fund, specifically whether the fund should focus on three or four sustainable development goals (SDGs).

About 3.4 per cent of the 49,552 members invited to the survey answered the question on whether to add or leave out a fourth SDG. This survey was consequential, which meant that – whatever the results – the board committed to implementing them.

“No pension fund has ever committed ex ante to the results of a survey,” says Rob Bauer, Professor of Finance at Maastricht University, one of the authors of the paper resulting from the survey titled, Get Real! Individuals Prefer More Sustainable Investment.

“We are not aware of any pension fund that gave its members a consequential vote on the investment strategy of the whole pension fund,” the authors say in the paper.

 

Members’ input

Pensioenfonds Detailhandel is a lean organisation with only seven employees and a lot of passive investments. Several years ago it moved into sustainable investing, with Bauer, who is also executive director at the International Centre for Pension Management, advising them at the time.

Their initial sustainability strategy included engaging with companies and voting their preferences around three of the United Nations’ Sustainable Development Goals – it had chosen the goals of climate action; decent work and economic growth; and peace, justice and strong institutions.  They also chose to exclude a limited number of companies including controversial weapons stocks.

In more recent times the board expanded their focus to include sustainability in the investment process, rather than just have it as part of engagement and voting.

“They decided this was not enough and wanted to look at including sustainability in their investment process, but they wanted a mandate from their members,” Bauer says.

The fund wanted to explore adding a fourth SDG, namely responsible consumption and production (such as no child labour), engaging Bauer and his colleagues from Maastricht, Tobias Ruof and Paul Smeets, to engage with members.

An extensive survey ensued consisting of three parts.

The first part familiarized all respondents with the concept of sustainable investment and introduced the SDGs. In the second part they measured the social preferences of participants as well as financial return expectations around sustainable investment. The third part focused on exclusion preferences.

The survey found that 67 per cent of the members surveyed were in favour of expanding to a fourth SDG.

Importantly, the survey also revealed that the choice for more sustainability was driven more by social preferences than financial beliefs, Bauer says.

The survey found that even those members that said adding a fourth SDG would result in lower returns, mostly voted in favour of adopting the fourth SDG.

“Even among those who expect four SDGs to yield lower returns, 57.7 per cent chose four SDGs. Thus, even when people expect to be worse off, they favour the more sustainable option,” the paper says.

“There was a willingness to pay,” Bauer says.

“There is a big risk that if you ask these questions in the wrong way there is a high cost. The design of the question was very important, as the answer depends on how you frame the question.”

He believes this paper has added to the academic literature, with both co-authors behavioural economists, and they will take this approach to the insurance and the private banking sector.

The High Level Expert Group on Sustainable Finance is contemplating asking financial services providers in Europe to survey clients on their sustainability profile. The provider will then need to make sure the clients’ portfolios are in line with their survey preferences. This may also come to the pension sector.

The study by the Maastricht professors could add value to the framing of these questions.

 

Implementation

Four days after the results of the survey were published, the board made the decision to add the fourth SDG.

Pensioenfonds Detailhandel is now actively looking at how to implement the addition of a fourth SDG across its investment process.

The fund has instructed its engagement overlay manager to take consideration of the fourth SDG, and is working with an index provider to re-weight its passive exposures based on the sustainability scores of these four SDGs.

The fund is also spending more time on voting. In 2017 it engaged with 246 corporate boards to promote sustainability.

“The board makes decisions all the time for the average member, and there is always someone that’s not happy. The survey found 67 per cent of members surveyed said to implement the fourth SDG. The board thought really hard and decided to ask members,” he says.

In the next of this new regular series, we examine the relationships that evolved as Sweden’s AP2 decided to invest with local managers in China. The story examines the process for choosing and monitoring Chinese managers, and the burgeoning focus on sustainability in that market.

Swedish fund, the SEK345 billion ($39.1 billion)AP2, jumped straight into the deep end when it decided to invest in China six years ago. At that time it mandated 1 per cent of AUM to three local managers to run stock picking strategies in its inaugural investment in China A shares in 2013. This included a $270 million allocation to Cephei Capital Management, part of alternative manager CDH Investments.

The relationship saw Cephei’s long-term, value approach coupled with AP2’s insistence and guidance on a sustainability lens, and is a lesson on how to succeed in investing in China.

“In 2017 our allocation to China A shares returned an average alpha of 30 per cent,” says Patrik Jonsson head of manager selection, public assets at AP2. “That’s 3,000 basis points, not 30 basis points. It was quite astonishing.”

Getting started

AP2’s China journey started in 2005 when it isolated five key reasons to invest. Familiar now but novel at the time, this included a desire to benefit from the structural changes reshaping the Chinese economy and the diversification benefits of an allocation to China.

The process stalled when multiples for China A Shares shot up and valuations looked out of whack; then the financial crisis struck and the whole idea was put on hold.

By 2011, A Shares were no longer trading at such a premium and AP2 applied for – and was swiftly granted – a Qualified Foreign Institutional Investors (QFII) licence and allocated a quota. It all happened so quickly the pension fund was forced to decline its first quota because it hadn’t secured managers and it couldn’t fulfil the requirement that quotas must be filled in 30 days. Given the ease of the process it remains a source of surprise to Jonsson that AP2 is still one of the few Swedish institutional investors in China.

“In early 2018 there were only four Swedish QFII licence holders able to invest in China. I have the impression that we are pretty alone in this field and that really surprises me,” he says.

One problem lies in finding a local partner.

AP2 chose six managers, although it has only allocated to three so far: APS, Cephei and UBS. It’s shortlist was whittled down from a long list of 30 in a lengthy selection process based on alignment around long-term value investing and sustainability.

For many long-term investors the high turnover among Chinese equity managers and the quick money culture is off-putting, explains Li Gang, chief executive at Cephei. He’s trying to build a different culture at the firm where clients now include Stanford University, Norway’s Central Bank and Abu Dhabi’s ADIA.

“Research analysts have an average life span of three years in our mutual fund industry. At Cephei we emphasis partnership – more than 12 of our senior staff are shareholders,” he says.

Other concerns also needed to be overcome. Jonsson, who travels to China twice a year to visit the managers on their home turf, joined AP2 in 2015 and needed to get under the skin of the three managers. But Cephei was the hardest to get to know.

“One reason was the language barrier since not all staff at Cephei are fluent in English and translators at meetings are common. I had the feeling that I was missing out on detail,” he recalls. “However, every time we met the team we grew more confident. They were on top of risk control and understood the importance of sustainability,” Jonsson says.

That detail was important given AP2’s active China strategy was a change of tack from its quant approach across its SEK113 billion ($12 billion) allocation to global and emerging market equity.

Cephei’s bottom-up strategy focuses on picking stocks in healthcare, financial services, manufacturing and companies benefiting from China’s industrialisation. Fifteen researchers propose companies for a stock pool where each is rated according to short and long-term characteristics made up of criteria like sector outlook, core competence, growth potential, and the quality of management. Based on this, stocks are classified into buckets or tiers which dictate the amount Cephei will invest.

“We can only construct portfolios from stocks in the stock pool,” says Li.

At this point Cephei’s portfolio managers take over and risk management becomes the priority.

“We are not a high growth investor. High growth demands very expensive valuations that we don’t understand and can’t justify. We focus on value and growth at reasonable valuations,” says Li, who became a convert to long-term, value strategies and their ability to generate alpha when he was running the equity sales desk for China’s largest investment bank China International Capital Corporation. He left in 2006 to set up the CDH offshoot Cephei Investments and run public equity allocations for QFII clients.

Put to the test

It wasn’t long before Cephei’s long-term, value approach was put to the test. In late 2014 / early 2015 Chinese equities rallied more than 50 per cent, driven by the bank sector and high beta names. Cephei ignored short-term trading pressures and the small, speculative stocks but it caused the manager to significantly underperform.

“At the end of 2014 the market was up over 50 per cent; we trailed it by more than 10 per cent,” Li syas.

Then it was AP2’s turn to show its commitment.

“I wasn’t with AP2 at the time, but I can imagine my colleagues at the fund would have felt the stress of allocating to China in a benchmark agnostic way and one year on, seeing significant underperformance,” says Jonsson.

As it was, the experience helped cement the relationship on both sides:  AP2 was reassured that Cephei stuck to its principles and did what it had said it would, and AP2 proved that when the going got tough, it wouldn’t jump ship to a better performing manager.

“They supported us at a difficult time and that is precious capital in China,” said Li.

In a sign of AP2’s growing confidence, Jonsson extended the benchmark agnostic approach to give the managers even more freedom to deviate from MSCI’s China index and expand its alpha hunting grounds. AP2 also increased it’s A Shares allocation to 2 per cent of total assets under management.

“It didn’t’ really make sense to limit them on tracking error because we were asking managers to ignore the benchmark,” says Jonsson who ensured thatall three were involved in setting the new risk limits which included a heightened focus on concentration risk to ensure diversity.

“Because we had their feedback and input, they couldn’t come back to us and say their performance had been hampered due to this, or that, limitation,” he says.

Not only did that decision inform 2017 returns, it also reduced volatility. “The really interesting thing is that although all the managers have been given freedom from a risk perspective, analysis shows their strategies have less volatility than their peers or the index.”

Sustainability

Low volatility and high returns is one holy grail. For AP2 sustainability is another. It lies at the heart of strategy to the extent every external manager must score well to secure an allocation, in a process that is then ongoing for its Chinese managers. The fund asks managers “constant questions” and demands a “report back” on ESG factors across all holdings on a quarterly basis. It’s a process that Jonsson explains often leads to a clash of manager opinions where the portfolios overlap.

“We don’t judge whose right or wrong; it’s interesting to hear different views on the same topic,” he says.

Although Cephei won the mandate for its grasp and willingness in the area, it wasn’t something the manager had spent much time on before. Nor is it easily applied to Chinese A shares.

“AP2 pushed us on ESG and at the time it was like a foreign concept in the China A share market,” Li says.

But Cephei’s lead on sustainability has made its relationship with AP2 unique. Jonsson says that the manager’s engagement with portfolio companies is taking the ESG message to the China A share market, where many firms have weak scores because of poor disclosure, for the first time.

In a sign of its commitment Cephei has put new resources and frameworks into sustainability, like establishing an ESG committee with representatives from the firm’s risk management, research and investment teams. It is also working with MSCI, recently meeting with the index provider to learn how it can beef up its approach.

“We also gave them our thoughts and feedback. It wasn’t a one-way presentation but a very productive, thought provoking discussion,” says Cephei’s investor relations head, Frank Fan in a nod the manager’s growing expertise.

“It’s all about attitude; we don’t think ESG is a reporting burden. We believe that ESG helps pick better companies and makes better investments. We are very proud of playing an instrumental and constructive role in the China A shares market,” Fan says.

A growing cohort of institutional investors are “impressed” by Cephei’s ESG team, admits Li.

Jonsson goes further, believing that the manager has carved a niche that will allow it to draw much more capital going forward.

“They are at the forefront of Chinese managers adopting ESG. It will help them attract more capital from institutions like ourselves,” Jonsson says.

Neither are worried that growing competition will crimp the success they’ve had. MSCI has just announced the intention to increase the weight of China A shares in its indices from 5 per cent to 20 per cent, and as China’s market becomes more efficient at allocating capital and pricing risk, so it will get more difficult to generate alpha.

It’s not going to happen tomorrow, says Li who predicts ample room to outperform in the years to come.

 

In my last column, I discussed how the widening income inequality gap is becoming a pressing challenge for investors today. As I noted then, institutional investors are increasingly realising that inequality can negatively impact their portfolios. This can be seen clearly on a global scale with modern slavery and human trafficking.

A $150 billion illicit industry with one in 185 people affected in 2016, modern slavery is prevalent across the world. Structural inequality is, of course, at the heart of modern slavery and a lack of access to credit is a major driver of vulnerability to such exploitation.

Investors and the broader financial sector are taking note, not least because of the increased regulatory attention on modern slavery issues. In the UK, a Modern Slavery Act has been in place for several years. Similar legislation just came into force in Australia at the federal level and, in parallel, in the most populous state of New South Wales. Several other countries are considering similar legislation and several European countries have adopted mandatory due diligence requirements that also cover the financial industry. Investors have increasingly strong reasons to understand how the presence of modern slavery and human trafficking in the operations and supply chains of companies within their investment portfolio creates risk for them.

At the same time, there is a growing recognition that firms that have strong anti-slavery practices in place may provide important investment opportunities – not only for social impact investors, but also more broadly.

Yet until recently, the role that the financial sector can play in this fight has been something of an afterthought for anti-slavery actors. This, despite the crucial rolethat the City played in financing structural transformation of the British trade and finance systems to move them away from reliance on slave labour in the Nineteenth Century. The financial sector intersects with these forms of exploitation in a variety of ways, from unwittingly laundering illicit funds generated from slavery to investment in businesses engaged in these forms of exploitation. Labour trafficking can be embedded deep in value chains.

As the Chair of the Financial Sector Commission on Modern Slavery and Human Trafficking, known as the Liechtenstein Initiative, we are working to put the financial sector at the heart of efforts to identify, target and disrupt these crimes and their underlying causes.

The Commission is a public-private partnershipbetween the Governments of Liechtenstein, Australia and the Netherlands as well as a consortium of Liechtenstein banks, philanthropic foundations and associations. United Nations University Centre for Policy Research serves as the Secretariat. The Commission consists of 23 Commissioners, including survivors, leaders from hedge funds, commercial and retail banks, institutional investors, development financing organisations, global regulators, the UN and NGOs. This very structure reflects the need to approach this issue through a collaborative multi-stakeholder approach.

We launched the Commission at the 73rdSession of the UN General Assemblyin September last year, with Australian Foreign Minister – the Commission’s co-convenor – remarking that, “it is not enough to be reactive and simply detect illicit financial transactions; investment decision-making must actively consider the risks of modern slavery.”

This was further reinforced in the comments by the Minister’s fellow co-convenor, Professor Muhammad Yunus, Nobel Laureate and microcredit pioneer. He spoke about the deep economic root causes for such vulnerability and growing levels of inequality worldwide.

That is precisely why the Commission is looking at both reactive and proactive measures as well as current limitations and opportunities from existing frameworks and regimes, as well as new innovations that the financial sector could utilize.

Our first meetingin New York focused on financial sector compliance issues, particularly Anti-Money Laundering and Counter-Terrorist Financing (AML/CFT) norms, supply chain due diligence and reporting. We considered the opportunities within and limitations of current regimes, including the need for better data to inform risk analysis. The Commission was mindful of the risks of over-zealous de-risking. Terminating business partnerships could actually push businesses into illicit financing arrangements and, counterproductively, make people more vulnerable to modern slavery and human trafficking.

In January, the Commission met in Liechtensteinto turn its attention to responsible lending and investment. The Commission was briefed by experts on how financial institutions can use and build leverage and also on how the financial sector can provide remedy to survivors. The briefing paper for this consultation, commissioned from Shift, analysed how the United Nations Guiding Principles on Business and Human Rights provide a framework for innovation by both public and private sector financial institutions to address modern slavery, human trafficking and related human rights concerns.

The Commission will visit Australia in April for our third global consultation. Our meeting in Sydney will explore financial innovation, including innovative financing instruments and financial technology that can empower communities and decrease their vulnerability to these types of exploitation. Beyond our Australian consultation, we will then meet in the Netherlands in June 2019 for our final consultation before the release of a roadmap to inform accelerated engagement by the financial sector in September 2019.

Our final product will include a roadmap with strategic expressways for action, providing opportunities for every corner of the sector to play its part. We will be actively disseminating this to key groups and institutions worldwide. As we know all too well from other efforts, compliance with existing legislation is not enough. We must take strong proactive steps if we are to achieve the Sustainable Development Goals, which will – for investors and the global community alike – end up paying dividends down the road.

Infrastructure equity prices do not exist in a vacuum. Analysing hundreds of transactions over the last 15 years, we found that they are driven by systematic risk factors, which can be found across asset classes. In other words, markets did process information rationally and average prices did reflect buyers’ and sellers’ views and preferences for taking risk.

These risk factors (size, leverage, profit, term spread or value) are commonplace for sharemarket investors. After all, unlisted infrastructure equity is still equity. As a result, unlisted infrastructure prices have been partly correlated with public markets over the last 15 years.

The price formation process happened almost in slow-motion, however, because of the illiquid nature of the unlisted infrastructure market.

The raw data shows unlisted infrastructure companies such as ports, airports and merchant power, experienced a sharp drop in revenue in 2009. But unlike stocks, the effect on valuations was not immediate because few transactions took place at the time. This shock to revenues and earnings impacted transaction prices only later on.

Then, in 2011, despite revenue growth being either stable or still declining, average infrastructure valuations began rising rapidly. This continued until 2016. Not all sectors peaked at the same time. For instance, the power sector started a new price decline in 2015. In contrast, airports had their highest average valuations increase in that period. By 2017, despite the return of revenue growth, average prices had plateaued, mostly due to the impact of the leverage factor (an increase in the price of credit risk) and of rising interest rates.

This decade of price increases can be considered a normal process of price discovery. Prices increased rapidly as more investors entered the market and buyers and sellers discovered how much they were willing to pay for infrastructure assets. During this period, the risk preferences of the average buyer of private infrastructure companies also evolved, leading to lower required returns for infrastructure investments.

Today, a price consensus may have been reached; ‘peak infra’ may even have occurred two years ago, as valuations followed a steadier path.

Of course, there are always exceptions to price increases. Vinci’s recent acquisition of a majority stake in Gatwick airport valued the London property at eight times revenues, while the data suggests that an average airport should sell for 2.5-3 times revenues. But the price Vinci paid for Gatwick may not be considered fair value by everyone.

We are on the cusp of a new era for infrastructure valuations. These businesses are expected to deliver steady and predictable cash flows and, to the extent that this is the case, they should be expensive. Prices will continue to evolve more rationally as more informed buyers and sellers engage in a steady stream of transactions in the most active markets.

This is good news for investors who have been looking to infrastructure for stable, long-term investments. Unlisted infrastructure may be driven by common equity factors, but it remains partly decorrelated from public markets and has a visible track record of steady and significant dividend pay-outs. The infrastructure investment narrative still holds.

With the period of easy returns driven by ever-increasing valuations coming to an end, a new era of risk management can begin for infrastructure investors, one that requires better measures of risk and of the contributions infrastructure assets make to the total portfolio.

 

Frederic Blanc-Brude is director of the EDHEC Infrastructure Institute. Sarah Tame is chief communications officer at EDHECinfra.

 

This paper is drawn from the EDHEC/LTIIA Research Chair

http://edhec.infrastructure.institute/wp-content/uploads/publications/blanc-brude_and_tran_2019.pdf

 

 

Factor investing offers a big promise. By identifying the persistent drivers of long-term returns in their portfolios, investors can understand which risks they are exposed to and make explicit choices about these exposures. An oft-cited analogy is to see factors as the nutrients of investing. Just like information on the nutrients in food products is relevant to consumers, information on the factor exposures of investment products is relevant to investors.

This analogy suggests factors cannot be arbitrary constructs. What would you think if Nestlé used its own definition of saturated fat for the information on its chocolate packets and McDonald’s also had its own, but different, definition for the content of its burgers? Further, would it not be curious if both definitions had nothing to do with the one nutritionists and medical researchers used?

This is exactly the situation that we find ourselves in when it comes to information about factors. Investment products that aim to capture factor premia have gained popularity. Investors rely heavily on analytic toolkits to identify the factor exposures of an investor’s portfolio. However, neither investment products nor analytic tools necessarily follow the standard factor definitions that peer-reviewed research in financial economics has established.

Investors will benefit from understanding and controlling their exposure to factors only if they are reliable drivers of long-term returns. Factor definitions that have survived the scrutiny of hundreds of empirical studies and have been independently replicated in a large number of data sets are, of course, more reliable than ad hoc constructs used for the purposes of a product provider. Unfortunately, such best practices for data are not observed in the investment industry.

In a recent study, we discuss factor definitions used in investment products and analytical tools offered to investors and contrast them with the standard academic factors. We also outline why the methodologies used in practice pose a high risk of ending up with irrelevant factors. References to the academic and practitioner research, and exhibits illustrating our arguments, can be found in the study.

The Risks of Deviating from Academically Validated Factors, Scientific Beta White Paper, February 2019

 

Are factors grounded in academic research?

Factor models link returns of any investment strategy to a set of common factors. In addition to the market factor, commonly used factors include size, value, momentum, profitability and investment. They capture the variation among returns across firms with different characteristics. In financial economic research, a small number of models have become workhorses for analysing asset returns and fund manager performance, given the consensual understanding that they contain the factors that matter for asset returns. Providers of factor-based investment tools and strategies unequivocally claim that their factors are “grounded in academic research”. However, we show that the factors they use are inconsistent with the factors that are supported by a broad academic consensus.

In academia, different models use identical factor definitions, the number of factors is limited to a handful and factors are defined by a single variable. These three properties mean that the different factor models draw on few variables – ones that have been identified as persistent drivers of long-term returns.

In contrast, the factor tools from commercial providers typically include a proliferation of variables. MSCI’s “Factor Box” draws on 41 different variables to capture the factor exposures of a given portfolio. S&P markets a “Factor Library” which, despite including more than 500 variables “encompassing millions of backtests”, wants to help you “simplify your factor investing process”. BlackRock proudly announces “thousands of factors” for its Aladdin Risk tool.

Why do the standard models avoid such a proliferation of variables? First, the need for more factors is often rejected on empirical grounds. One study shows that using 71 factors does not add value over a model with two simple factors (book-to-market and momentum) and another study shows that a model with four simple factors does a good job at capturing the returns across a set of nearly 80 factors. Second, academic research limits the number and complexity of factors because a parsimonious description of the return patterns is likely to be more robust that way.

 

Non-rewarded versus rewarded factors

Several definitions of the term ‘factor’ exist. Some of them focus on the variability in returns (i.e., short-term fluctuations) and others on the expected returns of assets (i.e., long-term average returns). One type of factor can be used to describe common sources of risk across assets. In this setting, volatilities and correlations among the assets are driven by exposures to a certain set of factors. While this information can provide some understanding of the fluctuations in a portfolio, it does not explain what drives long-term returns. Such factors are referred to as non-rewarded factors. Naturally, there are a number of such non-rewarded factors that can help capture short-term fluctuations. For example, short-term fluctuations of an equity portfolio may be explained by its sector exposures or by its exposure to countries, currencies or commodity risks – among many other possibilities. However, since such factors are not rewarded, an investor does not gain additional returns from such exposures.

Rewarded factors are those that explain differences in the long-term expected return of the assets. Knowledge about these enables an investor to tilt a portfolio towards stocks with high exposure to a factor that is positively rewarded. Investors need to be cautious to avoid misinterpreting a factor offered in commercial factor tools as rewarded when it is actually not. Dividend yield, for example, is included in the factor model of MSCI because it is a source of “time-varying return and risk”. However, it does not explain cross-sectional differences in the long-term expected return.

Spurious factors

A severe problem with commercially used factors is the process by which they are defined. It increases the risk of falsely identifying factors, due to weaknesses in the statistical analysis. In fact, providers will analyse a large set of candidate variables to define their factors. Given today’s computing power and the large number of variables representing different firm characteristics, such an exercise makes it easy to find so-called factors that work in the given dataset. However, these factors will probably have no actual relevance outside the original dataset. This problem is well known to financial economists.

 

Selection bias

Simply seeking out factors in the data without a concern for robustness will lead to the discovery of spurious factors because of the selection bias of choosing among a multitude of possible variables. The practice of identifying merely empirical factors is known as ‘factor fishing’. Therefore, a key requirement for investors to accept factors as relevant is that there be clear economic rationale as to why exposure to this factor constitutes a systematic risk that requires a reward, and as to why it is likely to continue producing a positive risk premium. In short, factors selected on the sole basis of past performance, without considering any theoretical evidence, are not robust and must not be expected to deliver similar premia in the future.

In addition, there are statistical tools to adjust results for the biases arising from testing a large number of variables. A recent study shows that it is easy to find great new factors in backtests but they add no real value to standard factors. Moreover, these factors do not survive more careful vetting. These results emphasise that it is easy to discover new factors in the data if enough fishing is done, but such factors are neither economically meaningful nor statistically robust. Of course, exposure to non-robust factors with an unreliable backtest performance will not prove useful to an investor going forward. The past will give an inflated picture of the factor-based performance.

 

Composite scores

We have emphasised that a stark problem arises when providers of factor tools select flexibly from among many variables. It turns out that the actual problem is even worse in practice. Providers of factor products and tools do not stop their data-mining practices at selecting single variables. Instead, they create complex composite factor definitions drawing on combinations of variables. Research shows that the use of composite variables yields an overfitting bias. This arises because combining variables that give good backtest results provides even more flexibility to seek out spurious patterns in data.

For a given combination of variables, changing the weight each variable receives in the factor definition may have a dramatic impact on factor returns.

 

What do providers do?

Given the well-documented risk of biases leading to useless factors, providers of factor products should use the academically validated definitions. Indeed, many providers claim that their factors are grounded in academic research. MSCI, for example, recently issued a report that clearly emphasises this. It states that the firm’s “factor research is firmly grounded in academic theory and empirical practice”. FTSE also mentions the broad academic consensus that exists for the factors used in its global factor index series.

It is important to highlight, however, what having a strong academic foundation should mean. To claim that a specific factor is “firmly grounded” in academic research means that it should fulfil two criteria. First, its existence should be replicated and documented across different independent studies. This gives investors the assurance that the methodologies are externally validated and that the factors exist outside of the original data set. Second, a risk-based explanation should support the existence of the factor. Without this, there is no reason to expect the persistence of the performance. Post-publication evidence is needed to confirm that the factor does not disappear after it is published. To support a claim for academically grounded factors, providers should be able to list the independent studies showing that these two requirements are fulfilled.

This does not mean that using new or proprietary factors will necessarily fail out of sample. However, it is not possible to obtain the same assurances for the effectiveness of the factor without academic grounding. A prudent approach is to select only factors that have been replicated independently. With this in mind, why would one rely on provider-specific research concerning a new factor when you have free due diligence from the academic community concerning a standard set?

It is clear that the use of proprietary factors exposes an investor to risks that can easily be avoided.

Whereas product providers use factor names that are usually based on those presented in the literature, the actual implementation is very different. Our study gives some examples of variable definitions that different index providers use as a proxy for factors. These can be compared with the definitions academics use. It is clear provider definitions are more complex than academic ones and differ substantially from the externally validated factors, despite using the same labels, such as “value” and “momentum”.

A relevant question for investors is whether the ‘upgraded’ definitions of standard factors, like  “enhanced value” and “fresh momentum“ add value only in the backtest or if the benefits hold after publication (i.e. in a live setting). Moreover, in the absence of external replication of such factors, investors are fully reliant on provider-specific results.

Many providers use composite scores in their factor definitions. As discussed above, this opens the door for an overfitting bias, even if composites are equal-weighted across constituent variables.

Overall, product providers explicitly acknowledge that the guiding principle behind factor definitions is to analyse a large number of possible combinations in short data sets and then retain the factors that deliver the highest backtest performance. In fact, providers’ product descriptions often read like a classical description of a data-snooping exercise, which is expected to lead to spurious results. For example, one provider states that, when choosing among factor definitions, “adjustments could stem from examining factor volatilities, t-stats, information ratios”, with an “emphasis on factor returns and information ratios”. Another provider states that “factors are selected on the basis of the most significant t-stat values”, which corresponds to the technical definition of a procedure that maximises selection bias.

Factor definitions providers use may appear to be advantageous in practice. Notably, this is the case when index providers offer both analytical tools and indices. If an analytical tool and a set of indices are based on the same factor definitions, the indices will show an exposure to the factors by construction. However, if the factors are flawed to start with, such correspondence does not add any real value to investors.

 

Redundant factors

Many factors used in investment practice are well known to fail to deliver a significant premium. For example, different analytics packages include the dividend yield, leverage, and sales growth as factors, while all of these have been shown not to deliver a significant premium.

Factors may also be redundant with respect to consensus factors from the academic literature. In other words, many proprietary factors may have return effects that can be explained away by the fact that they have exposures to standard factors.

Popular factor products and tools contain a large number of factors that do not deliver an independent long-term premium. This is bad news for investors who are using such tools to understand the long-term return drivers of their portfolios.

 

Conclusion

Factors used in investment practice show a stark mismatch with factors that financial economists have documented. Commercial factors are based on complex composite definitions that offer maximum flexibility. Providers use this flexibility to seek out the factors with the highest performance in a given dataset. Such practice allows spurious factors to be found. Spurious factors work well in a small dataset but will be useless in reality. Therefore, many factors that appear in popular investment products and analytic tools are likely false.

Even though many providers claim their factors are grounded in academic research, we have emphasised that two important conditions to support this claim are often not fulfilled. The factor definitions should have been used and validated across different independent studies and a risk-based explanation should support the existence of the factor. Without these assurances, there is no reason to assume the persistence of the factor.

We also show in our study that relying on proprietary factor definitions can lead to unintended exposures. For example, investors who tilt towards a composite quality factor will end up with a strategy where, depending on the index we consider, only about a third or half of the excess returns are driven by exposure to the two well-documented quality factors (profitability and investment). This means the part of the excess returns that is unrelated to quality factors can be as high as two-thirds, an obvious misalignment with the explicit choice to be exposed to quality factors. Even if the quality factors perform as the investor expects, this performance will not necessarily be reflected in portfolio returns, which are in large part driven by other factors and idiosyncratic risks.

Understanding the factor drivers of returns increases transparency and allows investors to formulate more explicit investment choices.However, they must also be wary of exposures to useless factors, which have no reliable link with long-term returns. A good idea can easily be distorted when implemented with poor tools. For a meaningful contribution to the ability of investors to make explicit investment choices, factor investing should focus on persistent and externally validated factors.

 

Felix Goltz is head of applied research, EDHEC-Risk Institute and research director at Scientific Beta. Ben Luyten is a quantitative research analyst at Scientific Beta.

 

The challenges for new California Public Employees’ Retirement System CIO Ben Meng were laid bare at the $340 billion pension fund’s February board meeting.

CalPERS is only 70 per cent funded and increasingly mature; it faced its first negative equity market in a decade in 2018 yet, with a 7 per cent return hurdle, is committed to keeping a large allocation to risk assets in what Meng called a “no pain, no gain” strategy.

Meng, who left his role as deputy CIO at China’s $3.2 trillion State Administration of Foreign Exchange to take over from Ted Eliopoulos in January, has just lost chief operating officer Elisabeth Bourqui following her resignation after just seven months. CalPERS also needs to fill long-standing vacancies in roles heading up the private equity and fixed income teams. Meng is also working with three new members on CalPERS’ 13-strong board: Mona Pasquil Rogers, Fiona Ma and, most notably Jason Perez, the police sergeant from Corona, California, who ousted board president Priya Mathur in an election upset last October.

Equity risk

The biggest challenges for the CalPERS portfolio reside in the public and private equity allocations. A key task is navigating risk in a $178 billion listed equity portfolio and the vulnerability to a drawdown that brings. Even though CalPERS’ allocation to growth assets (public and private equity) is 58 per cent of the portfolio, it represents 83 per cent of risk, Andrew Junkin, president of CalPERS consultant Wilshire Associates told the board at the meeting.

“If there is a significant sell-off, your portfolio is not insulated because it is still 83 per cent of risk in your portfolio,” Junkin warned.

Yet Meng’s options are limited because CalPERS’ funded status and need for a high return force it to take a degree of risk. His solution is to be “smart” about what, when and how much risk to take.

Smart strategies include “sticking to our course, even during times of inevitable market volatility”. He pointed out that to the board that last year’s equity drawdown was relatively small and noted efforts to mitigate the impact of a large equity market drawdown via diversification and defensive strategies. He also said there were only “modest” amounts of leverage in the portfolio and, most important of all, adequate liquidity coverage, which he believes is the best hedge against a fall in equity.

Indeed, Meng intends to focus more on ways to develop CalPERS’ liquidity profile during his first 180 days, developing what he calls a comprehensive, proactive liquidity management tool.

“This will be the front and centre of my focus area,” he told the board.

He is hunting for a liquidity sweet spot that ensures enough on hand to allow the fund to take advantage of market drawdowns, but not so much that it loses out on returns.

“Too much liquidity is costly but too little liquidity is deadly,” he said.

 

Not long-term anymore

Some CalPERS board members would like to see much more focus on downside risk.

“I just need to remind everyone that I don’t believe we should have a false sense of security that we are a long-term investor anymore,” board member Dana Hollinger warned. “We are at 68 per cent funded, we have asymmetrical risk – we have more of our population maturing than coming into the system. We have to get through these next five to 10 years by focusing on our downside risk and there is a point at which you can’t recapture.”

CalPERS has a ratio of one active employee for every retiree, compared with a 4 to 1 ratio at the fund’s inception.

Hollinger wasn’t alone. Mindful of last year’s spike in volatility, board member Betty Yee wanted to know how successful measures to reduce volatility had been and asked the investment team for closer analysis, going forward, of how much lower the returns would have been without defensive measures in place.

Private equity

Resolving the inherent challenges in CalPERS’ $28 billion private equity portfolio remains another “dilemma”, Meng said. Accessing top-quartile private equity funds so the pension scheme can make the annual $8 billion-$10 billion deployment necessary to ensure its target 8 per cent allocation to its best-performing asset class has become critical.

About two-thirds of CalPERS’ private equity allocation sits in traditional co-mingled fund-of-funds investment, in so-called Pillar II of the portfolio. Here, investments are tilted to large and mega-buyout funds run by managers like Blackstone, Carlyle, CVC Capital Partners and TPG. However, the number of top-quartile managers is limited, and these managers come to the market only every three or four years. The best general partners also seek a diversified limited partner base, and for this reason don’t want to take money only from CalPERS.

“One place your scale has meaningful disadvantages is that it is hard to get money deployed,” Junkin said.

Internal constraints also thwart CalPERS’ ability to deploy capital in Pillar II, including a commitment to invest more in secondary and co-investment opportunities.

“The private equity staff has not been budgeted to the $8 to $10 billion a year, they’ve been budgeted a lower number,” said Steven Hartt, principal at private equity consultant Meketa Investment Group, who referenced the “interaction between the private equity team and the broader CalPERS staff” and the need to “think about what’s budget they’re going to be able to deploy”.

The investment team also told the board how CalPERS staff were working to “re-energise” the manager program, “refresh” and “add” to the pool of managers to choose from, and “re-engage” with opportunistic transactions around co-investments and secondaries “that have not been done in the last several years”. For the second half of 2018, staff completed eight commitments totalling $3.1 billion, part of 18 commitments totalling $6 billion for the full year.

Meng stressed the urgent need to push ahead with CalPERS’ new, direct-style Innovation and Horizon pillars in the private equity program. These pillars focus on late-stage investment in technology, life sciences and healthcare companies, and on long-term investments in established companies, respectively.

Both will allow CalPERS to exploit its advantages in scale, brand and an improved liquidity profile, to access opportunities when they arise, Meng said.

Under these pillars, which are still awaiting board sign off after a year of discussion, CalPERS will fund Innovation and Horizon investments as the sole limited partner in a traditional LP/GP relationship. Meng kicked any idea of CalPERS building its own in-house private equity allocation into the long grass.

“Our current governance structure, and the fact that we’re not located in a global financial centre, seriously hinders our ability to attract the expertise in-house,” he said.