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Factor equity investing

Considerations for reserve managers
28 August 2019
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    Key takeaways

    • In theory, factor investing aims to explore new drivers for diversification, improve portfolio transparency and risk management, and enhance investment returns
    • Academic research demonstrates that, over the long-term, a factor approach can achieve superior risk-adjusted returns against a traditional market cap investment
    • In practice, factors have been seen to perform differently in different market regimes, which can lead to relatively long periods of underperformance. This makes it crucial for investors to determine their investment horizon and to agree on a clear definition of the factors to which they want exposure
    • From a sovereign investor's perspective, the non-standardised investment framework of this approach – especially the lack of benchmarks – goes against a more traditional way of thinking
    • Constructing factor equity portfolios also comes with increased operational complexity and a need for new risk management tools. Explaining this to internal stakeholders can be an arduous task
    • Nevertheless, and in spite of operational and practical hurdles, there are clear benefits to following a factor approach. Practically, it can provide reserve managers with a more granular understanding of the underlying risk and return of their portfolio
    • Ultimately, the potential excess returns of factors versus market cap strongly depends on the targeted tracking error, but marginal gains can make a substantial difference in the long-term