Institutional investors should consider factor investing as a strategic decision.
Recent academic papers identify factors that deliver abnormal returns across asset classes and markets. Consequently, implementing factor investing as an integral part of top-down strategic investment decision-making becomes a key asset and risk management decision for institutional investors that invest in global equity and bond markets. Institutional investors should explain this strategy in a clear and transparent way to their stakeholders.
In a novel academic paper, Do Institutional Investors Manage Factor Exposures Strategically?, Dirk Broeders from Maastricht University and Kristy Jansen from Tilburg University study how institutional investors incorporate factor investing in their investment strategies.
Although factor investing receives a lot of attention, the traditional approach for institutional investors, such as pension funds, is to focus on the optimal stock-bond allocation and, in some cases, alternative asset classes such as real estate, private equity, and hedge funds. Broeders and Jansen assess the factor exposures of institutional investors in the Netherlands, i.c., occupational defined benefit pension funds. The Dutch occupational pension system is economically important because assets under management equal approximately 1.6 trillion and represent 54 percent of total pension funds’ assets in the euro area. Next to the market and credit risk factors, the authors focus on value, momentum, carry, and low beta for both equities and fixed income portfolios. The latter four are constructed as zero cost, long-short factors and have a significant positive mean return for both equities and fixed income.
Broeders and Jansen find a striking difference between factor investing in equity and fixed income portfolios. Based on two key findings the authors claim that pension funds manage equity factor exposures strategically. First, value, momentum, carry, and low beta factors explain differences in expected equity returns between pension funds to a large extend. Second, the factor exposures for equity portfolios are stable over time. By contrast, support for strategic decision-making in fixed income factor exposures cannot be found. Differences in expected fixed income portfolio returns across pension funds are mainly driven by market exposures. The impact of long-short factor exposures on return differences is negligible. In addition, over time the fixed income factor exposures vary much more than strategic decision-making would suggest. The average fixed income factor exposures can get as low as -0.6 and as high as 0.8.
The authors go further and analyse what drives factor exposures. They document that pension fund characteristics, delegated asset managers and exogenous events drive factor exposures. Amongst others, Broeders and Jansen report the following interesting results. Size, measured as assets under management, does not have an impact on the exposures to long-short factors. This observation means that contrary to common belief, large pension funds are not constrained in implementing factor strategies. Further, for both equity and fixed income, asset managers play a non-trivial role. The five most often contracted delegated asset managers amplify factor exposures in either direction. The effect of asset managers on factor exposures may be driven by differences in beliefs about factor investing. Finally, it is shown that momentum, carry, and low beta factor exposures increased sharply following the start of the Global Financial Crisis in 2008 and then reversed sharply around the peak of the euro sovereign debt crisis in 2012. The euro sovereign debt crisis has moved Dutch pension funds away from government bonds in southern Europe to ‘safe haven bonds’ with lower carry ranks, such as German and Dutch government bonds.
