The urgency to address climate change will carry on, regardless of what the US government does, with investors, companies and world leaders sticking to the path of emissions reduction.

“The decision by the US is disappointing but it won’t derail progress on climate change,” says Fiona Reynolds, managing director of the Principles for Responsible Investment, in reaction to President Trump’s announcement that the US would withdraw from the 195-nation agreement on climate change reached in Paris in 2015.

“In fact, this move could strengthen the resolve of other countries to fulfil their commitments to the Paris Agreement,” Reynolds says. “Most world leaders understand the urgency involved in addressing climate change and want to leave a legacy for future generations. For example, China, which has taken the lead on green finance, has said it will continue its push in this area, regardless of what the US decides to do…We congratulate the other G7 countries that confirmed their recommitment to climate action, all of which would welcome the US back into the fold if and when [it chooses] to re-enter the accord.”

Momentum even in the US

Even in the US itself, momentum continues despite Trump’s announcement, with 83 mayors across the country honouring the Paris Agreement, including the mayor of Pittsburgh, Pennsylvania, whose city got special mention in Trump’s announcement. (“I was elected to represent the citizens of Pittsburgh, not Paris,” Trump said.)

California, New York, Washington and six other states have committed to cutting emissions by 26-28 per cent from 2005 levels, which was the reduction former president Barack Obama proposed under the Paris Agreement.

Paul Simpson, who is chief executive of CDP, which runs the global disclosure system that enables companies, cities, states and regions to measure and manage their environmental impact, says any country that fails to implement the Paris Agreement is increasing risks for itself, which increases the impetus for others to act.

“US cities and states are also at the forefront of the fight against climate change,” Simpson says. “New York and California are targeting 50 per cent renewable electricity generation by 2030, and they have ambitious targets in place to drastically reduce their greenhouse gas emissions. Leading cities and states are proving that huge leaps forward are possible, with or without the support of the federal government.”

In the private sector, the investor community is becoming increasingly vocal about climate change, as evidenced by the 282 investors, representing $17 trillion, who recently sent a letter to G7 and G20 leaders urging them to stand by the Paris Agreement, PRI’s Reynolds says. (Global-Investor-Letter-to-G7-G20-Governments)

Investors are also voting with their feet. Last month, ExxonMobil management was instructed by investors with a majority of shares to report on the impact of global measures designed to keep climate change to +2 degrees or less.

“This action shows that regardless of the US position on climate, the momentum around climate change is unstoppable.” Reynolds says.

Simpson adds that there are more than 260 major global corporations – including US giants Dell, Kellogg Company, PepsiCo and Walmart – that have joined the Science Based Targets initiative, committing to cutting their emissions in line with the latest climate science.

“Companies are driving a surge in demand for renewable energy, with Apple, Bank of America, Google and Starbucks among the growing number of influential corporations committed to 100 per cent renewable power through the RE100 initiative,” he says. “All of these key players in the global economy will continue taking action because they understand the economic opportunities on offer and the risks associated with continuing business as usual.

“Last year, 2000 companies disclosing to CDP reported cost savings of $12.4 billion as a result of emissions-reduction projects, while nearly 400 cities identified more than 1000 economic opportunities from climate action. Meanwhile, our data showed that $906 billion in annual corporate turnover is at risk because of deforestation. As the world moves closer to its zero-carbon goal, demand for sustainable investments, products and services from investors, purchasers and citizens will keep growing, further reinforcing the business case for swift and ambitious action.”

About 820 investors, with combined assets of $100 trillion, request information on climate change, water or forests from CDP.

Imagine a world where resources used in one industry are used again in another so that maximum value is extracted, recovered and used again. Or where consumers replace users as people lease – rather than own – products, through collective ownership or sharing platforms. Imagine renewable energy and the continuous cycling of materials have slashed reliance on non-renewable natural resources for good.

It’s called a circular economy – the alternative to today’s traditional, linear economic model of ‘take, make and dispose’. And far-sighted investors should embrace it for both long-term returns and impact, a new report urges.

The report, Investing in the New Industrial (R)evolution, comes from The Investment Integration Project (TIIP) and impact investment community Toniic. It builds on themes explored in TIIP’s 2016 Tipping Points report, which found more investors taking practical steps to incorporate global issues such as health, food and energy into their strategies, in a ‘systems-level’ approach.

The next evolutionary step in a systems-level approach is to adopt investment strategies to integrate circular-economy principles.

The report references compelling statistics. In 2014, America’s largest businesses sent 342 million metric tons of waste to landfills and incinerators in millions of dollars of lost value; each year, the global economy disposes of 95 per cent of plastic packaging, worth an estimated $80 billion-$120 billion; the average car in Europe is parked 92 per cent of the time and the average office is used only 35 per cent to 50 per cent of the time, even during working hours.

“Increasingly, a linear business carries risks. Just as there is a growing awareness of the risk of climate change to the economy, we can also see that not adopting circular principles will eventually lead companies to a lagging market position and decreased valuations,” argues Frido Kraanen, director co-operative and corporate sustainability at PGGM, the Dutch manager with $220 billion in pension assets under management and a member of the Circular Economy 100, a group dedicated to building the circular economy.

“Solutions often embrace new smart technology, sharing platforms or ownership models, giving us insight into potential investment opportunities,” Kraanen says. “The transition to a sustainable, circular business model will be increasingly demanded, not just as a nice extra for reputational purposes, but as a core tenet of business.”

A lens through which to invest

The authors of the TIIP/Toniic report urge investors to include circular-economy principles in their investment decisions, the same way some have included a systems-level approach – as a lens through which to invest, rather than an asset class in itself.

The report argues investors should state a commitment to the circular economy and prioritise it in stock selection and portfolio construction. They should screen to favour companies with innovative reuse strategies and investments in technology, products and services that will accelerate the adoption of circular-economy practices.

Active investor engagement with companies will encourage them to move from linear to circular operating models, and investors should introduce targeted programs and select managers that prioritise circular-economy practices.

Opportunities are emerging

The authors acknowledge “it may still be difficult” to identify circular economy opportunities in each asset class but believe they are beginning to emerge. Active stock selection could include companies such as clothing manufacturer and retailer H&M, whose circular policies include providing vouchers to customers who return used clothes, and reusing those items either as new clothes or in other industries.

Computer manufacturer and software developer IBM could be another choice. It sells so much refurbished equipment that, in 2014, 97 per cent of about 36 million tons of harvested computer scrap was resold, reused or sent to material recycling.

Opportunities in fixed income include the municipal bond market, where investors could target assets such as water utilities and waste-water treatment facilities, making progress on reuse and recycling. Real-estate investment could focus on properties with water recycling or that draw zero net energy from the grid.

More opportunities will emerge as investor pressure encourages incremental progress towards adoption of circular-economy strategies in large corporations or at an industry-wide level. Eventually, the investment universe will be immense.

“Given the wide applicability of the circular economy, its increased adoption will create investment opportunities that span asset classes, industries and geographies,” the report’s authors state. “The increasing need for capital will help meet the growing demand for investments in global systems. Investors and asset managers would benefit from investment opportunities that deliver both measurable impact and resilient financial returns.”

Obstacles to overcome

Developing a circular economy does hold many challenges. Materials can be hard to identify and separate after use and there are few cost-efficient ways to separate materials without degradation. For example, only about $3 worth of raw materials can be extracted from a smartphone that contains roughly $16 worth of raw materials. Also, unlocking the circular economy’s full potential will require the collaboration of multiple stakeholders; governments and other regulatory bodies must ensure the adequacy of legal frameworks and create incentives.

The road is long but PGGM’s Kraanen is clear: the potential for a new economic order is huge and investors need to get on board.

“The move towards a circular economy should not be a sub-divisional goal of some far-removed CSR [corporate social responsibility] department, but an integral part of investment strategy,” Kraanen says. “Through capital and engagement, financiers should be supporting, incentivising or otherwise promoting the shift.”

“Investing in sustainable infrastructure is the growth story of the future.”
• Global Commission on the Economy and Climate, 2016

The world needs more infrastructure, particularly in developing countries. But not just any infrastructure. To achieve the economic, social and environmental objectives embodied by the Paris Agreement and the Sustainable Development Goals (SDGs), this infrastructure must be sustainable, low-carbon and climate resilient. The New Climate Economy’s 2014 report, Better Growth Better Climate, estimates that from 2015 to 2030, the global requirement for new infrastructure assets will be $90 trillion, more than the value of the world’s existing infrastructure stock.

To meet these needs, annual investment in infrastructure will need to increase from current levels, about $3 trillion, to $6 trillion. At the same time, data from the Organisation for Economic Co-operation and Development and alternative assets researcher Preqin shows investors’ allocations to infrastructure are gradually increasing, driven by a combination of factors (such as low yields in traditional asset classes and inflation protection).

Together, these should be positively reinforcing developments. But are they? The Inter-American Development Bank (IDB) commissioned Mercer to assess the extent to which infrastructure investors – and other stakeholders, including governments, multilateral development banks (MDBs) and infrastructure industry initiatives – are focusing and collaborating on sustainable infrastructure. Our findings are somewhat mixed: the positive momentum of new initiatives focused on sustainable infrastructure is countered by the fact that sustainability concerns struggle to enter the core allocation strategies of mainstream investors.

Our initial report, published in November 2016, Building a Bridge to Sustainable Infrastructure, outlined the effort underway to raise awareness of sustainable infrastructure investment opportunities and develop tools to foster related investment analysis and monitoring. However, as outlined in the companion paper, Crossing the Bridge to Sustainable Infrastructure, we find that the level of investor awareness and engagement with these developments seems relatively limited. In addition, current allocations to infrastructure fall short of the levels required to support economic development, The New Climate Economy found in 2016. To overcome these barriers, we set out a call to action for investors, governments, MDBs and industry initiatives (see infographic).

What is sustainable infrastructure?

In a broad sense, sustainable infrastructure is socially, economically and environmentally sustainable. The specific application of this concept will depend on the relevant geographical and sector contexts. But ultimately, sustainable infrastructure is that which will enable the world collectively to meet the SDGs and the Paris Agreement.

Some investors have the misconception that sustainable infrastructure simply means more renewable energy infrastructure. Indeed, investment flows into renewable energy have been increasing; for example, in 2016, more than 40 per cent of new infrastructure investment went into renewables, data from Preqin shows. Although this is positive, sustainable infrastructure needs are broader. The New Climate Economy’s Better Growth Better Climate outlines in detail the change that is required across three critical economic systems: cities, land use and energy.

In addition, infrastructure needs to be resilient in the face of a changing climate. A 2016 study of public-private partnerships (PPPs) by Acclimatise found that “Among the sample of 16 national PPP policy frameworks examined, not a single one was found to mention a changing climate, climate resilience or adaptation.”

Investor interviews show lack of progress

As part of our research, we spoke with a number of infrastructure investors about the extent to which they consider sustainability in their decision-making. Despite growing attention to ESG considerations within investment organisations, we found that many infrastructure teams are just now developing a formal approach to sustainability in investment and, further, that such considerations are generally applied at the deal level. There is little top-down thinking about the transformational change and investment pathways that must accompany successful implementation of the Paris Agreement and the Sustainable Development Goals (SDGs), and the opportunities that they offer to investors. When considering the reasons for the lack of progress, we identify the following factors:

Lack of familiarity with the sustainable infrastructure business case and a related lack of experience in considering what might qualify

Limited standardisation of tools and approaches, with barriers to entry for investors

Lack of co-ordinated policy commitments across regions and sectors consistent with the Paris Agreement and the SDGs, which dampens investors’ focus on energy transition risk (that is, the risk associated with swift action to mitigate climate change)

Lack of tools and focus on climate resilience (that is, adaptation), which has seen little prioritisation to date. 

Investors noted an interest in learning more about the merits of a sustainable infrastructure approach and in gaining the know-how to achieve it. To date, industry initiatives have not been successful in providing such knowledge and would benefit from greater clarity about what constitutes sustainable infrastructure and its business case.

Call to action

Despite some high-level commitments to sustainable development by policymakers, and the significant efforts underway to leverage private-sector finance, there is still a lack of engagement from many infrastructure investors. Thus, a call to action is essential. We highlight three key initiatives, as outlined in the following graphic:

 

 

 

If you invest in infrastructure, we encourage you to review Crossing the Bridge to Sustainable Infrastructure and develop an approach that enables your organisation to optimise risk and return considerations for the long term, while being cognisant of the role your investments play in the transition to a low-carbon and sustainable economy.

Jane Ambachtsheer is partner and chair, responsible investment, at Mercer. Amal-Lee Amin is climate change division chief at Inter-American Development Bank.

 

In long-horizon investing, ‘lock-up’ is a term that attracts much attention and debate. In theory, it would give asset managers a stable capital base for effectively pursuing their long-term strategy without worrying about being forced to sell by redemptions.

This is particularly important given the fact that some of the best returns can be made in times of market distress, which is when asset owners often seek to redeem investments. However, for various reasons, many owners are reluctant to commit to locking up capital (particularly in long-only public markets).

In this article, I review open-end and closed-end structures in the context of some findings from academic research.

Intuitively, in an open-end structure, provision of liquidity to investors (redemption) can have a negative impact on returns; for example, in fire sales that price assets below fair value to meet redemption calls. The empirical evidence clearly lends support to this argument. Roger Edelen, from the Wharton School of Business, in his paper “Investor flows and the assessed performance of open-end mutual funds”, built a sample of 166 open-end mutual funds and concluded that liquidity-driven trading in response to flows has reduced returns of US open-ended mutual funds by 1.5 per cent to 2.0 per cent per year from 1985 to1990.

In a separate study, the US Securities and Exchange Commission’s Woodrow Johnson constructed a proprietary database that includes a panel of all shareholder transactions (just under a million, on 50,000 stocks) within 10 funds in one mutual fund family between 1994 and 2000 in the US. His findings are similar to Edelen’s: the cost of open-endedness is about 1.1 per cent a year.

Johnson further suggested that under the current structure (i.e., no pricing differentiation with regards to trading frequency), long-term shareholders who have relatively small liquidity demand are, in effect, subsiding short-term shareholders who access liquidity. In my mind, this raises the question of whether open-end structures in their current form are fit-for-purpose for long-horizon investors.

It’s not that simple

Now we might be tempted to conclude that – everything else being equal – closed-end funds should, in theory, outperform because they can avoid being forced sellers. Well, unfortunately, not everything is equal here. The lack of monitoring and alignment (in the absence of the threat of redemption) can lead to serious agency costs and underperformance for closed-end funds. Barclay et al found that the greater the managerial stock ownership in closed-end funds, the larger the discounts to net asset value. The average discount for funds with blockholders (shareholders who own 5 per cent or more of the fund’s common stock) is 14 per cent, whereas the average discount for funds without blockholders is only 4 per cent.

Researchers attributed the agency costs to blockholders extracting private benefits – such as receiving compensation as an employee – and blockholders owning companies receiving fees for service to the fund, as examples.

Both structures can succeed

As with many situations in investment, there doesn’t seem to be a universally agreed upon winner of this debate. Both structures could potentially add value and both structures could destroy it if ill-executed. If asset owners can manage to get themselves over the line about the concept of lock-up, and a proper monitoring mechanism is in place, closed-end funds do seem to give managers the highest degree of freedom to turn their skill into better returns.

On the other hand, an alternative to requiring lock-up could be looking for ways of avoiding the cross-subsidy between flighty investors and committed long-term investors, along with providing a better and deeper articulation to asset owners of how long-term strategies should be assessed and measured. This could include a clear articulation of the underlying long-term investment thesis and specification of when the strategy is likely to underperform.

With that, when short-term underperformance inevitably comes around, asset owners are more likely to stay on course as long as the underlying investment thesis remains intact.

 

Liang Yin is senior investment consultant in the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.

The University of Toronto Asset Management Corporation (UTAM) manages the institution’s C$8.8 billion ($6.5 billion) pension and endowment assets. Its performance is benchmarked against a traditional 60/40 reference portfolio where key characteristics are passive management in public markets, simplicity and low cost.

Although the reference portfolio comprises only equity and fixed income, UTAM has the flexibility to invest in other assets, such as private equity and hedge funds. These assets are classified under the most appropriate reference portfolio asset class.

Within this framework, UTAM’s new president and chief investment officer, Daren Smith, guides a new six-person, expert investment committee. He has honed a sophisticated, outsourced strategy informed by his prior roles at the fund, which he joined in 2008.

“We are trying to outperform the reference portfolio but we don’t make any significant macro bets away from it,” Smith says in an interview from UTAM’s Toronto offices.

With 60 per cent of the portfolio in equities and the strong returns of recent years expected to taper, Smith’s focus is working with the best managers ahead of a tougher climate.

“We are not set up to take significant bets where we would underweight equities based on the view that [these] markets are overvalued,” he explains. “We are about finding best-in-class managers that can outperform over a market cycle and in a downturn, hopefully, preserve more capital than the benchmark.”

Passive US equities, active international

For now, he favours passive US allocations and active international strategies. US shares represent 20 per cent of the benchmark allocation, an area where Smith says outperforming the S&P 500 benchmark with traditional managers is tough.

“We looked at traditional long-only managers in US equity, found the ones we thought were best in class, looked at the fee schedules and didn’t have the conviction that active traditional managers would outperform,” he recalls. [It’s why] a large proportion of our US equity is passive.”

Would equity long-short hedge funds perform any better?

“We’ve evaluated whether these funds can outperform the long-only benchmark,” Smith responds. “The reality, in our view, is that it is extremely difficult for a typical equity long-short manager to outperform a long-only benchmark. They may have a higher Sharpe Ratio and less volatility, but when you look at the returns, we find most of the value tends to be on the long side, and then we find most of that value is gross of fees. Net of fees, a significant proportion of that value is eroded.”

Not much private equity

What about private equity? He explains that any investment in private equity requires conviction that the allocation would outperform not only passive markets but also the next best alternatives, which are more liquid – such as a traditional long-only or hedge fund manager – to compensate for locking up assets for a long time.

“The hurdle for private equity is not the usual benchmark returns,” he explains. It’s an analysis that leads him to conclude: “Plain vanilla US private equity is not attractive and the expected returns don’t appropriately compensate investors for locking up capital for such a long period of time. It’s not an area we are actively focusing on at this time.”

In international private equity, applying the same analysis has led UTAM to favour long-only and extension strategies – an allocation that is 15 per cent of the benchmark.

“We’ve been able to find managers that are traditional long-only or extension managers who have significantly outperformed the relevant public-market benchmark. This is the hurdle an international private-equity manager would need to meet, and so far we have little international private-equity exposure.”

UTAM hedges 50 per cent of its currency exposure from US and international equity allocations, in a strategy that leaves the fund with a 32.5 per cent foreign currency exposure. Smith explains that the fund has been overweight US dollar exposure for the last four years, but now that the US dollar is strengthening, UTAM is sticking much closer to the benchmark currency exposure.

“In the past, it was a slam dunk to be overweight the US dollar because the dollar was undervalued and had a risk-reduction benefit for a Canadian investor. It is rare to have something in a portfolio that both reduces risks and is expected to add value.”

Opportunistic in private credit

As equity markets challenge investors, so does private credit. UTAM’s opportunistic credit portfolio comprises strategies including direct lending in Europe, Asia and the US, credit long-short hedge funds, an allocation to mortgages, and a mandate with a special situations Asian manager focused on non-core bank assets and non-performing loans.

“We try to go after different opportunities created by dislocations in the market. In many cases, this has been where banks have retrenched or pulled out of the market,” Smith says. “The objective of this portfolio is to deliver 8 per cent plus net returns with as little risk as possible. If we have to take more risk than we are comfortable with to get to 8 per cent, we will drop the 8 per cent objective.”

The direct lending space has become “less compelling” and UTAM is not re-upping with most of its direct-lending managers, he says.

Uncorrelated returns come from an absolute return portfolio set up in 2011, in an allocation that targets returns of cash plus 4 per cent with low volatility and no market beta. UTAM allocates to nine managers, 70 per cent of which run equity market neutral/low net strategies, with the remainder in global macro.

“Only a small sub set of hedge fund strategies are appropriate for this mandate, because there is traditional beta in most hedge fund strategies. We would argue your typical equity long-short hedge fund manager would have a beta north of 0.3 or 0.4 to the market,” he says.

Smith notes that at “a point in time”, the absolute return portfolio may have a long market exposure, due to global macro strategies, where managers take directional views. Yet over “a market cycle”, he doesn’t want managers “to have a static bias one way or another”.

Responsible investing

Smith says the portfolio has met all its objectives, outperforming the cash return objective and a customised index.

UTAM has 40 core managers, selected and managed by an internal team of seven. He has expanded environmental social and governance (ESG) integration at the fund and just produced a first Responsible Investing Report. This promises another lens through which to rate managers.

“We’ve developed a whole set of questions and processes to evaluate existing and potential managers from an ESG perspective,” he explains. “We want to know that the manager is aware of ESG risks that are relevant for their strategy and has taken these into account in underwriting. What we ultimately hope is that this makes us better at selecting and monitoring managers.”

At the end of 2014, Campbell Harvey, professor of finance at Duke University’s Fuqua School of Business, in the US state of North Carolina, reported that there were 316 supposed factors reported in top journals and working papers, with new ones being discovered at an accelerating pace – about 40 a year.

Harvey was the editor of the Journal of Finance from 2006-12 and in his first year handled 1275 manuscripts. With the advent of the smart beta tsunami, and the possible combination of these reported factors, how can investors possibly make decisions on where, what and how to use factors in their portfolios?

Luckily, most of the so-called factors can be ignored; in fact, Harvey described many of them as trading strategies rather than factors.

“There is confusion because there are hundreds that I would classify more as trading strategies, some are fleeting,” he says.

So how can investors get their head around factors? And is it possible to identify one that can earn a premium over the long term?

What is a factor, really?

According to Andrew Ang, managing director and head of factor investing at BlackRock, a factor is a broad, persistent source of return, seen across many different geographies and asset classes. To be properly called a factor, says Ang – who is a prolific author and academic on the subject, writing 2014’s Asset management: a systematic approach to factor investing – something must have been persistently rewarded for decades, and have been studied by academics and used in practice for decades.

This narrows the 316 factors Harvey discovered down to about four.

Experts agree that value and momentum are persistent and robust factors and, depending on one’s perspective, the other two are carry and defensive.

More importantly, Ang says, a factor needs as its backbone an economically sensible source of return.

“Is there a risk premium and does it come about from a structural impediment or from investor’s behavioural biases,” he asks.

For $187 billion investment manager AQR, there are two main criteria for identifying factors: robust empirical evidence across many different markets and contexts; and a strong economic theory to support why these returns existed in the past and therefore are likely to exist in the future.

“It’s all about persistence,” Ronen Israel, principal at AQR, says. “It’s important to recognise that the factors we talk about have an economic theory to support them, and you’re not just relying on data and empirical evidence, [quantitative details].”

“We don’t focus on that many factors, there are only a few that fit that criteria, we think, and that’s value, momentum, carry and defensive (or low risk),” Israel says.

Research on fundamental indexation, an alternative to market-cap-weighted indices, was first published in 2004 by Rob Arnott, now chair of Research Affiliates. Fundamental indexation, which uses equal weighted stocks, argues that cap weighting stocks systematically overweights overvalued stocks and underweights undervalued stocks. And for Arnott, the notion that a factor will produce positive alpha because it has produced positive alpha in the past is naïve.

“When Campbell published the paper showing there were 316 published factors, how many of them asked if the performance benefits from a tailwind of rising valuation? Did my factor get more expensive? No one asked that question. So the first robust test is whether a factor produces positive alpha net of valuation change. Nobody [checks] that.”

The second question, Arnott says, is does the factor work out of sample, across different time spans and geographies.

“We go through all of this and try to find factors that have legitimacy across many geographies net of valuation change, and there are very few,” he says, citing size, value and momentum as fitting that criteria.

“We don’t think that low volatility and quality have alpha, but they do have attractive attributes that people value.”

How to put them to good use

So, given that those with the experience of studying and making money from factors over many years believe that only very few truly exist, the next logical question is how investors should use them. That, Ang says, depends on the outcome the investor wants to achieve.

“What they want to achieve goes into two buckets – to reduce risk (then use minimum volatility or quality), or explicitly enhance your return (use value, momentum or size),” Ang says. “The starting point is a strategic allocation to complement a portfolio, so you add factors you might want to have or hedge factors you may have unintended exposure to. I’d recommend a multi-factor benchmark for this.”

After that, you might consider tilting around a strategic allocation, he says, adding that tilting also means other considerations, such as concentration and turnover, need to be assessed in evaluating the attractiveness of each factor.

Factors are not only difficult to time, AQR’s Israel says, but when timing is added as an objective, it becomes more difficult to be robust.

“Why bet on factors through different economic environments – you’re trying to bet on two things. That is demanding way too much from the data,” he says.

“Instead, take a long-term strategic view and be balanced – investors are generally underexposed to these ideas. The first order is to get the long-term strategic exposures to these ideas and let timing, and tactical shifts, be secondary.”

Arnott also prefers to get factors as robust as possible and not to play too many games seeking to optimise against fast-changing correlations.

“We try to marry factors with the fundamental index and rely on the fundamental index to create the structural alpha, not the factors, which we think are too unreliable as a source of alpha,” he says.

So while these factor experts might agree there is a small group of factors that fit the criteria of being robust and earning a premium over a long period of time, the definition of each one is not clear.

For example, the underlying concept of value is to buy cheap, and price-to-book is the generally accepted way to implement that. However, Israel says there is no one perfect measure.

“You are trying to capture cheap assets outperforming expensive, in the case of value. But there is no theory to support why [price-to-book] is the only metric to support that. Sales to price, or earnings to price, could be tests.

“Using one particular measure that worked well in one particular time period may not be the best [method] going forward. So applying multiple metrics, while staying true to the concept and basic idea, is a more robust way to do it.”

Arnott agrees that using the generally accepted Fama-French price-to-book definition of value is way too simplistic.

“If you combine sales-to-price, cashflow-to-price and dividends-to-price, which are all robust individually, it will be more robust,” he says. “Investors have a tough decision to make when choosing a manager. [It’s] about who has done the most robust [analysis], and determining whether the capacity is correct and the turnover is not excessive. Ultimately, the proof is the result, but you need a decade of results before you can make a decision.”

Technological triumphs

The advancement of technology has allowed implementation and execution techniques to evolve, which Ang says leads to more applications for those general concepts.

“It’s like writing a play using a quill,” he says of using only price-to-book as a measure of value. “Technology is central to everything we do.”

Israel advises, however, that there are good and bad things that come out of technology advancements.

“If technology leads to more data mining and factors that aren’t truly there, that’s a bad thing,” he cautions. “But that’s not what we’re talking about here. Being able to trade more efficiently, risk management and without unintended risks – they are all good things.

“And measures of crowding rely on data analysts and technology to be able to react to things, they are good things. But don’t deviate from the core economic ideas that are driving these ideas, and that’s not technology.”

So where to from here?

BlackRock’s Ang says the “biggest bang for your buck” is looking at factors in illiquid markets.

“Modelling of a total portfolio in liquid and illiquid markets is a data and technology story and that is totally transformative,” he says.

He argues investors should be holding investment opportunities everywhere they can.

“But if you don’t take a factor view, then just holding private equity doesn’t mean you are diversified from public equities. Both have a large exposure to economic growth,” he says. “We see value in private markets, there are lots of value effects in private equity and also in real estate. If we don’t take a factor view of the whole portfolio, then we might go into periods like in 2008-09 and see the effects of unintended drawdowns.”

So factors can be used to hedge unintended tilts or enhance returns across both liquid and illiquid markets. But as these four experts outline, factor investing is harder than it looks and should be approached through a long-term strategic lens.

The comments from Harvey, Ang, Israel and Arnott quoted in this article are taken from an Institutional Investor Journals webcast, “Factor Perspectives: Separating Factors from Fiction”.