a needed boost to portfolios. AJ Somal, a financial adviser at Aurora Financial Planning, says that among this clients: “There has been a shift to investing in alternative assets, and a move away from traditional asset classes like bonds and equities.”
He adds: “My clients have been investing in property (buy-to-let), peer-to-peer lending, and buying premium bonds – with the latter to mitigate tax.”
The alternative funds chosen for a portfolio depend on the role they are expected to play and how granular a portfolio manager’s fund selection and asset allocation are. Do they sit in an ‘alternatives’ allocation? Are they included under a ‘diversification’ heading? If they are more directional, do they actually sit in a portfolio’s equity risk budget?
lternatives are often defined in terms of what they do rather than what they are. To be sure, it is an asset class that does a lot: from the attractive risk-return profiles to working hard as a kind of insurance policy. Today many investors have recognised that a sizable allocation to alternatives can give
A
Alternatives today: providing value in the current market
A report by Investment Week
NO LONGER NICHE
In 2016, 344 new alternative funds were launched, compared to 10 in 1997. And further growth is on the horizon: a 2018 report by data tracker Prequin, The Future of Alternatives, predicts that the alternative investment industry will reach AUM of $14 trillion by 2023 – up from $8.8 trillion at the end of 2017. Much of this has been driven by the quest for diversification in an evolving market environment.
Equities and bonds are often characterised by an inverse relationship – meaning that when equity prices rise, bonds fall. However, this relationship can sometimes reverse, while factors such as regulatory changes and the impact of monetary policy have led to higher risks for both asset classes.
This has the effect of increasing the appeal of alternatives, which typically have low correlation to traditional asset classes – and to different assets that fall under the ‘alternatives’ umbrella.
At the same time, factors such as lower forward-looking return expectations and concerns about the prospect of a recession are contributing to interest in this sector. All of this means that alternatives have a role to play in most investment portfolios.
One of those important roles can be seen in the pensions landscape, which is constantly changing through new legislation, court decisions or alterations in practice. In a recent report by JLT Employee Benefits, they found that an allocation to professionally managed illiquid assets could increase defined contribution (DC) pensions by 10 percent. The firm suggested a 20 percent exposure to illiquid assets such as private equity, infrastructure or real estate, could enhance diversification and generate additional return.
Maria Nazarova-Doyle, head of DC investment consulting at JLT Employee Benefits, said: “The focus on daily-dealt funds with near 100 percent liquidity is a fundamentally impatient approach to DC. Many default strategies are currently failing to adequately diversify investments, precluding savers from the valuable illiquidity premium that can be accessed through alternatives.”
Commenting on the research, Gemma Siddle, chartered financial planner for Eldon Financial Planning, said: “Illiquid assets such as these need to be considered as a long-term investment and certainly not a short or medium term ‘bet’. It’s important that those investing in them understand the risks and potential benefits. However, carefully managed investment into these areas in other countries shows that such arrangements can be a success.”
BOOSTING PENSIONS
Targeted absolute return funds have enjoyed something of a surge in popularity over recent years, which should come as no surprise, since their main aim is to deliver positive performance regardless of market conditions. But this isn’t guaranteed and you may get back less than you put in.
In a bid to deliver consistent positive returns, these funds can employ a number of different investing techniques, and at times complex financial instruments, to help them to profit from the markets’ ups and downs. They can invest in equities, bonds and even currencies as well as a mixture of all of these and more.
One of the more common tactics they use to enable them to potentially make money even if markets are sliding is known as ‘short selling’ where the aim is to profit from falling share prices. But while demand for these funds tends to increase during periods of volatility, it’s vital to remember that there’s no guarantee that they can protect your capital – you may well lose money.
Louis Tambe, a fund analyst at FE, says this is a sector that can provide useful exposures, “whatever your views on markets”, noting that with heightened volatility and larger spreads between the most expensive and cheapest stocks, “if momentum doesn’t break out either upwards or downwards then there could be more room for fundamental equity long/short managers to separate the winners from the losers.” However, he warns that there is also more risk of getting this wrong, “so manager selection is important.”
THE ABSOLUTE RETURN ADVANTAGE
Tambe says that another potentially interesting area is that of defined return investments – in other words, assets which are typically held to maturity to lock in a yield – and structured products that only pay out in extreme market movements, “but pay a good return should they trade in a range.” But if markets were to start trending downwards, and if a crisis were to be on the horizon, “then allocating to more defensive assets is wiser” – an outcome which he says could benefit equity market neutral or global macro managers, as well as absolute return fixed income managers playing on longer duration and widening credit spreads.
Similar concerns have been expressed about alternatives as a whole. “The returns of alternative funds have not lived up to expectations,” comments Mattias Möttölä, Associate Director, Alternatives at Morningstar. “Many investors have bought them often to replace fixed-income investments, which yield very little, but the expected returns of alternatives have not materialised in many cases.” He notes that such funds do provide diversification benefits, and that a reasonably priced alternative fund with a strong manager and proven process can be a good fit to a portfolio – “but it’s important to understand the manager’s strategy to understand what you can realistically expect from the fund.”
It is clear that alternatives are not without their challenges, and the associated complexity and lower level of regulatory oversight is a concern for some. Consequently, it is particularly important to understand the performance of different asset classes and the implications of market developments. But despite this caution, alternatives continue to be widely used, with robust growth expected in the coming years. The Prequin report predicts that by 2023, 34,000 fund management firms will be active in this space – 21% more than in 2018.
The alternative investment universe contains a huge range of investment options, from asset leasing to infrastructure projects and everything in-between. Researching and valuing some of the more esoteric sub-asset classes can be difficult. Given the wide variety of options available, which have the potential to be true diversifiers for investors? With so many unique characteristics to the different investments, it takes specialist research in order to find the best opportunities the market has to offer.
ROBUST GROWTH
Alternatives fundraising (global private capital)
Billions USD
Demand for alternatives to strengthen
% of respondents planning to allocate more or less capital
2
1
There are many definitions of alternatives but some of the main types include commodities, specialist property, infrastucture and asset leasing....
Defining alternatives
Could solar energy help multiply returns for alternatives investors?
Jared Murray on Unsplash
READ MORE
Defining alternatives
There are many definitions of alternatives but some of the main types include commodities, specialist property, infrastucture and asset leasing. Once considered to only available to large institutional investors, these assets have moved to the mainstream as smaller investors look to add more diversification to their more traditional investments like bonds and equities.
A 2018 paper published by CAIA Association and the CFA Institute Research Foundation, Alternative Investments: A Primer for Investment Professionals, outlines three primary attributes of alternatives, any of which can lead an asset to be classified as ‘alternative’:
1. Returns are driven by exposures to underlying assets with non-traditional cash flows.
2. The returns of the investment are driven by complex trading strategies which result in “unusual risk exposures”.
3. Returns are structured to “generate non-traditional payouts”.
The report notes that in all of these cases, specialised methods of analysis are needed as returns do not mimic the returns of traditional asset classes – i.e. stocks and bonds.
CLOSE
Sources: (1) Preqin (2) Preqin, HFRI, J.P. Morgan Asset Management. Fundraising categories are provided by Preqin, and represent their estimate of annual capital raised in closed-end funds. Hedge fund fundraising numbers are represented by net flows and come from HFRI.Data are as of December 31, 2018.
SECTOR REVIEW
ALTERNATIVES
New adventures in alternatives
Simple, intuitive and effective: avoiding the data mining trap
Alternatives today: providing value in the current market
New adventures in alternatives
Simple, intuitive and effective: avoiding the data mining trap
Alternatives today: providing value in the current market
IN THIS ISSUE
Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
By Natixis Investment Managers
Simple, intuitive and effective: avoiding the
data mining trap
New adventures in alternatives
SHARE
reinsurance, asset backed securities or aeroplane leasing – others can provide welcome diversification to plain vanilla portfolios. And in times of market stress, a diversified approach is much needed to help boost returns and smooth losses.
In this guide NN Investment Partners discuss the value of factor investing, and how the best factor strategies have a sound economic underpinning without being over-engineered.
We also hear from Natixis’ UK sales head, Darren Pilbeam, who discusses how alternative strategies can provide a different lens through which to view market volatility.
Alternatives do carry with them associated complexity and a lower level of regulatory oversight. So they are not without their challenges. But in a world of lower growth, a good deal of uncertainty and the feeling that traditional investment options are under delivering, alternative investments may just be the answer.
lternatives are often defined in terms of what they do rather than what they are. To be sure, it is an asset class that does a lot: from the
A
READ MORE
Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
Simple, intuitive and effective: avoiding the
data mining trap
By Natixis Investment Managers
New adventures in alternatives
CLOSE
There are many definitions of alternatives but some of the main types include commodities, specialist property, infrastucture and asset leasing. Once considered to only available to large institutional investors, these assets have moved to the mainstream as smaller investors look to add more diversification to their more traditional investments like bonds and equities.
A 2018 paper published by CAIA Association and the CFA Institute Research Foundation, Alternative Investments: A Primer for Investment Professionals, outlines three primary attributes of alternatives, any of which can lead an asset to be classified as ‘alternative’:
1. Returns are driven by exposures to underlying assets with non-traditional cash flows.
2. The returns of the investment are driven by complex trading strategies which result in “unusual risk exposures”.
3. Returns are structured to “generate non-traditional payouts”.
The report notes that in all of these cases, specialised methods of analysis are needed as returns do not mimic the returns of traditional asset classes – i.e. stocks and bonds.
Defining alternatives
Invest less capital than in past 12 months
Invest more capital than in past 12 months
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Close
Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
Simple, intuitive and effective: avoiding the
data mining trap
By Natixis Investment Managers
New adventures in alternatives
ALTERNATIVES
Simple, intuitive and effective:
avoiding the data mining trap
The best factor investing strategies have a sound economic underpinning without being over-engineered.
In this interview lead portfolio managers from NN Investment Partners’ Factor Investing team Willem van Dommelen and Stan Verhoeven discuss the benefits of a multi factor investment approach and
the importance of
“cutting out all the noise”
READ MORE
Factor investing is an investment style that selects securities based on shared characteristics, or factors, that have proven to be persistent drivers of risk and returns...
What is factor investing?
We have seen factor investing assets grow signifcantly over the past decade. What do you see as the main developments within this space?
Source: (1) Harvey, C.R., Y. Liu, H. Zhu, 2015, …and the Cross-Section of Expected Returns, Review of Financial Studies:5-68
What is factor investing?
Factor investing is an investment style that selects securities based on shared characteristics, or factors, that have proven to be persistent drivers of risk and returns. The existence of factors has been extensively documented by academics and can be explained by three distinct drivers:
1. Compensation for risks that other investors want or need to transfer
2. Behavioural biases of investors causing assets to be “mispriced”
3. Compensation for providing liquidity in case of a supply and demand imbalance
As these drivers are generic, factors are present across all asset classes and markets and can be employed “bottom-up” (for individual security selection) and “top-down” (for market allocation). Given their return potential and diversification benefits, factors can be considered suitable building blocks to create “all-weather” portfolios.”
CLOSE
Willem: Well, investors have broadly embraced the concept of factor investing and the value it brings. In the last few years in particular, we have seen an increasing demand for factor-based strategies that go beyond single stock equities and extend into other asset classes, and that target an absolute return. This is a logical and valuable step because the drivers of factor returns, like behavioural biases, are present in all asset classes. By taking a multi asset class approach and combining long and short exposures, investors can further benefit from the added value that factors can bring, namely attractive and diversified returns.
Willem:
We’ve seen exponential growth in the number of factors. How do you manage the risk of investing in spurious factors?
Stan: This is clearly a risk. Harvey and Zhu(1) named this phenomenon the “factor zoo” as a reflection of the significant increase in the number of factors documented in academic literature. Most of these so-called factors are the result of data-mining, and will probably be unable to deliver excess returns out of sample.
Even though academic literature will continue to provide us with research insights, we believe it is vitally important for managers to research the factors themselves before deciding which ones to adopt. More importantly, as also suggested in the Harvey and Zhu study, a clear economic rationale should be driving the research to help eliminate the risk of spurious factors.
At NN IP we make sure our factors are as simple as possible in order to control the risk of data-mining. Before any data analysis takes place, we extensively review the economic underpinning and the expected behaviour and performance of a factor strategy. Only if the factor behaves according to our economic rationale – and if it is robust and profitable after accounting for transaction costs and other forms of slippage – will it be included in our portfolio.
Stan:
The last few years have been turbulent, with QE, Brexit and other geo-political events. How did this impact your factor strategy?
Willem: Yes, we’ve had QE in the market for over a decade but QE is not the first time the central banks stepped in. The value investing approach has been shown to be profitable for almost a century, and during that time central banks have taken many more actions than QE. When it comes to factor investing it is crucial to maintain a long-term view and not be distracted too much by shorter-term dynamics that make people believe that this time it’s different. We therefore rely on a very disciplined research and investment process, where we do not apply discretionary overlays to avoid falling into such typical pitfalls.
We have been managing our NN (L) Multi Asset Factor Opportunities fund since 2016. Since then we have been confronted not only with QE, but also with the EU referendum, US elections and a sharp drop in equities in December 2018. During this period our strategy has generated strong returns, which confirms our view that a broadly diversified factor portfolio can deliver
an attractive return in all market environments.
Willem:
Where do you focus on in your research process? New factors?
Stan: It’s very unlikely that new factors will suddenly pop up but we do continuously research ways to create a more robust definition of a factor that adheres to our principle of simplicity. Doing things simply and cutting out the noise involves a lot of hard work and a critical mind.
Next, we put significant effort in controlling transaction costs. Factors can generate a significant turnover, so there is a clear gain to be made there. Last, we extensively test how factors interact with each other to make sure they do not load on traditional investments like equities or on other factors.
We also want investors to clearly see our offering as diversified building blocks for their portfolio. Therefore we focus on ensuring they offer true diversification to other building blocks such as equities and fixed income. In this way, our research is geared to make sure that we deliver what we promise: attractive, diversified returns.
Stan:
Factor investing is often considered as a complex “black box”. How do you see this?
Willem: We disagree on the “black box” point. Factor investing is rule-based so all investment decisions can be disclosed and are consistent, or repeatable, through time. We provide detailed information to our clients, which include showing factor definitions, how we combine factors and how these have led to the overall positioning and performance of the fund. Our multi asset, multi factor approach is very transparent and quite the opposite of a “black box”. This is also what drives the success of factor investing. Clients understand what is under the bonnet and they subscribe to the benefits.
The approach of a non-systematic / discretionary manager is certainly more “black box” than what we do. This is because one can never look into the brain of such a manager to determine what drives his or her investment decisions, let alone whether those decisions have been consistent through time.
The more difficult element here is complexity, as that is a subjective matter. What is simple for one can be considered complex by others. We aim to overcome this challenge by keeping our factors as simple as possible with a clear economic underpinning.
Willem:
What do investors miss by not adopting an absolute return factor approach?
Stan: One of the basics of investing is to diversify one’s investments and, as such, create more robust portfolios. Factors are driven by different elements than traditional asset classes so they will behave differently and provide valuable benefits. To achieve this diversification benefit, the factors should not have structural long biases to traditional
Stan:
To what extent is factor investing commoditised?
Willem: Factor investing within equities has matured but we clearly see this isn’t the case for multi asset, multi factor absolute return offerings. Within that spectrum of factor investing we have seen consistent inflow. We see this asset growth coming mostly from investors who were initially invested in hedge funds, that applied similar strategies but in a more expensive and less transparent way, and were disappointed about performances in combination with a substantial cost base.
With the growing popularity of factors we do see a lot of offerings appear that use more complex approaches. We believe one should be wary of such complex and less transparent strategies as these are more subject to data-mining risk and thereby often show inferior performance out of sample.
Willem:
What if a factor stops working?
Stan: The existence of factors has been extensively researched, proven by academics and applied by practitioners. Behavioural biases are one of the drivers behind the existence of factors and we know that a bias doesn’t shift easily. Because investors have different objectives, this creates structural opportunities that can be captured using a factor-based approach.
Stan:
What kind of return expectations do factors offer?
Stan: At base we do expect all our factors to continue delivering attractive returns going forward. However, one should in fact be wary if a claimed factor has historically generated a Sharpe of more than 2. It also means that a factor can show a prolonged period of drawdown. We therefore advise to invest in multiple diversifying factors. By doing so, investors can overcome short-term negative performances of certain factors and still benefit from their return potential over the long term.
Stan:
As a seasoned factor investor, what advice would you give to new entrants into this field?
Willem: First, build a strong understanding of why factors exist and why they deliver attractive diversifying returns. Then, see how they are put into practice. Is there a disciplined research and execution process? How does one control the risk of data-mining or p-hacking? How robust, efficient and scalable is the platform used to perform the research and implement the strategies? And do not simply select based on superior back-test results. The combination of simplicity, transparency in terms of process and infrastructure, and “live” performance are the important elements to assess.
Willem:
return sources like the equity risk premium.
We therefore favour an absolute return
approach where we avoid these types of
biases and can deliver attractive returns
both in bull markets and bear markets.
We have proven this over the last three years. Our strategy has delivered very attractive returns, and although individual factors should not be considered the Holy Grail, we have shown that by combining multiple uncorrelated factors it is possible to generate very appealing risk-adjusted returns. To quote Aristotle: the whole is greater than the sum of its parts!
What do investors miss by not adopting an absolute return factor approach?
Stan: One of the basics of investing is to diversify one’s investments and, as such, create more robust portfolios. Factors are driven by different elements than traditional asset classes so they will behave differently and provide valuable benefits. To achieve this diversification benefit, the factors should not have structural long biases to traditional return sources like the equity risk premium. We therefore favour an absolute return approach where we avoid these types of biases and can deliver attractive returns both in bull markets and bear markets.
We have proven this over the last three years. Our strategy has delivered very attractive returns, and although individual factors should not be considered the Holy Grail, we have shown that by combining multiple uncorrelated factors it is possible to generate very appealing risk-adjusted returns. To quote Aristotle: the whole is greater than the sum of its parts!
We have proven this over the last three years. Our strategy has delivered very attractive returns, and although individual factors should not be considered the Holy Grail, we have shown that by combining multiple uncorrelated factors it is possible to generate very appealing risk-adjusted returns. To quote Aristotle: the whole is greater than the sum of its parts!
Stan:
READ MORE
Some factors are spurious. For example, in 2017 a Bloomberg writer designed her own factor model based on back testing US companies with “cat” in their names...
The cat factor
The cat factor
Some factors are spurious. For example, in 2017 a Bloomberg writer designed her own factor model based on back testing US companies with “cat” in their names.*
The model bought any US company whose name had “cat” in it, like “CATerpillar”, or “CommuniCATion”. What resulted was an 850,000% return six years to date.
Willem van Dommelen says: “The performance was largely due to the rallying of an untradeable penny stock.
So the return could not have been achieved in real life. Moreover, it lacked any form of economic underpinning and was therefore likely not to deliver excess return out of sample. What happened was this: when the article was published the index dropped again. This shows the importance of a thorough research process, and the ability to efficiently implement the factors that come out of it.
CLOSE
*Source: https://bloom.bg/2DydHka
Absolute Return
…when you have the ability to adapt, regardless of the market environment
Benefits from perceived incorrect valuations; hence we go long undervalued assets and short overvalued assets.
Benefits from the tendency of instruments with higher yields to outperform those with lower yields; hence we go long the instruments with a high yield and short those with a low yield.
Performance tends to persist; hence we go long the winners and short the losers.
Markets are subject to predictable and excessive buying and selling pressures in the short term; hence we go long excessive supply and short excessive demand.
Implied volatilities are generally higher than realised volatilities because implied volatility is a compensation, not an expectation, of volatility. We pay realised volatility and receive implied volatility.
Value
Carry
Momentum
Flow
Volatility
Factors applied with NN IP
The fund, which was launched in 2016 and has now posted a successful three-year track record, is the culmination of more than a decade of experience with factor investing within NN IP. It is a UCITS compliant fund aiming for capital growth. It follows a factor-based investment approach aiming to capture non-traditional sources of return, also known as factors. Exposures are taken to factors such as value, carry, momentum, flow and volatility across all the major asset classes (equities, fixed income, FX and commodities). The fund aims to avoid structural long/short biases and strives for low correlation with traditional asset classes, thereby offering diversification benefits.
Cumulative performance since inception
(I Cap USD), Net of fees (2)
Past performance is not a reliable indicator of future results. Currency movements can affect your investment returns. For more detailed information about the NN (L) Multi Asset Factor Opportunities fund, please refer to the prospectus and Key Investor Information Document available at www.nnip.com.
Introducing NN (L) Multi Asset Factor Opportunities
Source: (2) NN IP Performance Measurement. Data as of end March 2019. Fund was launched on 23 March 2016.
SECTOR REVIEW
ALTERNATIVES
New adventures in alternatives
Simple, intuitive and effective: avoiding the data mining trap
Alternatives today: providing value in the current market
New adventures in alternatives
Simple, intuitive and effective: avoiding the data mining trap
Alternatives today: providing value in the current market
IN THIS ISSUE
Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
By Natixis Investment Managers
Simple, intuitive and effective: avoiding the
data mining trap
New adventures in alternatives
SHARE
Home
Close
Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
Simple, intuitive and effective: avoiding the
data mining trap
By Natixis Investment Managers
New adventures in alternatives
SECTOR REVIEW
ALTERNATIVES
Simple, intuitive and effective:
avoiding the data mining trap
Jared Murray on Unsplash
The best factor investing strategies have a sound economic underpinning without being over-engineered. In this interview lead portfolio managers from
NN Investment Partners’ Factor Investing team Willem van Dommelen and
Stan Verhoeven discuss the benefits of a multi factor investment approach and
the importance of “cutting out all the noise”
stress, such as in February 2018, when both asset classes declined sharply in unison.
Meanwhile, the second half of 2018 saw a shift from synchronized global growth to an unsynchronized slowdown across regions. The fourth quarter of 2018, in particular, saw global equities fall by almost 13% – the Nasdaq was technically in bear market territory on 24 December, down 23% from its end-August peak. December was the worst month for US equities in 50 years.
With interest rates rising, central banks reducing their stimulus and market volatility increasing, 2019 is shaping up to be a complex and challenging investment landscape. Traditional asset classes like equities and bonds certainly still have their place in portfolios, but there’s an increasing need to think outside the box and look at the alternatives.
Willem: Well, investors have broadly embraced the concept of factor investing and the value it brings. In the last few years in particular, we have seen an increasing demand for factor-based strategies that go beyond single stock equities and extend into other asset classes, and that target an absolute return. This is a logical and valuable step because the drivers of factor returns, like behavioural biases, are present in all asset classes. By taking a multi asset class approach and combining long and short exposures, investors can further benefit from the added value that factors can bring, namely attractive and diversified returns.
We have seen factor investing assets grow signifcantly over the past decade. What do you see as the main developments within this space?
Willem: Well, investors have broadly embraced the concept of factor investing and the value it brings. In the last few years in particular, we have seen an increasing demand for factor-based strategies that go beyond single stock equities and extend into other asset classes, and that target an absolute return. This is a logical and valuable step because the drivers of factor returns, like behavioural biases, are present in all asset classes. By taking a multi asset class approach and combining long and short exposures, investors can further benefit from the added value that factors can bring, namely attractive and diversified returns.
READ MORE
Factor investing is an investment style that selects securities based on shared characteristics, or factors, that have proven to be persistent drivers of risk and returns...
What is factor investing?
CLOSE
Factor investing is an investment style that selects securities based on shared characteristics, or factors, that have proven to be persistent drivers of risk and returns. The existence of factors has been extensively documented by academics and can be explained by three distinct drivers:
1. Compensation for risks that other investors want or need to transfer
2. Behavioural biases of investors causing assets to be “mispriced”
3. Compensation for providing liquidity in case of a supply and demand imbalance
As these drivers are generic, factors are present across all asset classes and markets and can be employed “bottom-up” (for individual security selection) and “top-down” (for market allocation). Given their return potential and diversification benefits, factors can be considered suitable building blocks to create “all-weather” portfolios.”
What is factor investing?
We have seen factor investing assets grow signifcantly over the past decade. What do you see as the main developments within this space?
Willem: Well, investors have broadly embraced the concept of factor investing and the value it brings. In the last few years in particular, we have seen an increasing demand for factor-based strategies that go beyond single stock equities and extend into other asset classes, and that target an absolute return. This is a logical and valuable step because the drivers of factor returns, like behavioural biases, are present in all asset classes. By taking a multi asset class approach and combining long and short exposures, investors can further benefit from the added value that factors can bring, namely attractive and diversified returns.
We’ve seen exponential growth in the number of factors. How do you manage the risk of investing in spurious factors?
Stan: This is clearly a risk. Harvey and Zhu(1) named this phenomenon the “factor zoo” as a reflection of the significant increase in the number of factors documented in academic literature. Most of these so-called factors are the result of data-mining, and will probably be unable to deliver excess returns out of sample.
Even though academic literature will continue to provide us with research insights, we believe it is vitally important for managers to research the factors themselves before deciding which ones to adopt. More importantly, as also suggested in the Harvey and Zhu study, a clear economic rationale should be driving the research to help eliminate the risk of spurious factors.
At NN IP we make sure our factors are as simple as possible in order to control the risk of data-mining. Before any data analysis takes place, we extensively review the economic underpinning and the expected behaviour and performance of a factor strategy. Only if the factor behaves according to our economic rationale – and if it is robust and profitable after accounting for transaction costs and other forms of slippage – will it be included in our portfolio.
The last few years have been turbulent, with QE, Brexit and other geo-political events. How did this impact your factor strategy?
Willem: Yes, we’ve had QE in the market for over a decade but QE is not the first time the central banks stepped in. The value investing approach has been shown to be profitable for almost a century, and during that time central banks have taken many more actions than QE. When it comes to factor investing it is crucial to maintain a long-term view and not be distracted too much by shorter-term dynamics that make people believe that this time it’s different. We therefore rely on a very disciplined research and investment process, where we do not apply discretionary overlays to avoid falling into such typical pitfalls.
We have been managing our NN (L) Multi Asset Factor Opportunities fund since 2016. Since then we have been confronted not only with QE, but also with the EU referendum, US elections and a sharp drop in equities in December 2018. During this period our strategy has generated strong returns, which confirms our view that a broadly diversified factor portfolio can deliver an attractive return in all market environments.
READ MORE
Some factors are spurious. For example, in 2017 a Bloomberg writer designed her own factor model based on back testing US companies with “cat” in their names...
The cat factor
CLOSE
Some factors are spurious. For example, in 2017 a Bloomberg writer designed her own factor model based on back testing US companies with “cat” in their names.*
The model bought any US company whose name had “cat” in it, like “CATerpillar”, or “CommuniCATion”. What resulted was an 850,000% return six years to date.
Willem van Dommelen says: “The performance was largely due to the rallying of an untradeable penny stock.
So the return could not have been achieved in real life. Moreover, it lacked any form of economic underpinning and was therefore likely not to deliver excess return out of sample. What happened was this: when the article was published the index dropped again. This shows the importance of a thorough research process, and the ability to efficiently implement the factors that come out of it.
The cat factor
Where do you focus on in your research process? New factors?
Stan: It’s very unlikely that new factors will suddenly pop up but we do continuously research ways to create a more robust definition of a factor that adheres to our principle of simplicity. Doing things simply and cutting out the noise involves a lot of hard work and a critical mind.
Next, we put significant effort in controlling transaction costs. Factors can generate a significant turnover, so there is a clear gain to be made there. Last, we extensively test how factors interact with each other to make sure they do not load on traditional investments like equities or on other factors.
We also want investors to clearly see our offering as diversified building blocks for their portfolio. Therefore we focus on ensuring they offer true diversification to other building blocks such as equities and fixed income. In this way, our research is geared to make sure that we deliver what we promise: attractive, diversified returns.
Factor investing is often considered as a complex “black box”. How do you see this?
Willem: We disagree on the “black box” point. Factor investing is rule-based so all investment decisions can be disclosed and are consistent, or repeatable, through time. We provide detailed information to our clients, which include showing factor definitions, how we combine factors and how these have led to the overall positioning and performance of the fund. Our multi asset, multi factor approach is very transparent and quite the opposite of a “black box”. This is also what drives the success of factor investing. Clients understand what is under the bonnet and they subscribe to the benefits.
The approach of a non-systematic / discretionary manager is certainly more “black box” than what we do. This is because one can never look into the brain of such a manager to determine what drives his or her investment decisions, let alone whether those decisions have been consistent through time.
The more difficult element here is complexity, as that is a subjective matter. What is simple for one can be considered complex by others. We aim to overcome this challenge by keeping our factors as simple as possible with a clear economic underpinning.
To what extent is factor investing commoditised?
Willem: Factor investing within equities has matured but we clearly see this isn’t the case for multi asset, multi factor absolute return offerings. Within that spectrum of factor investing we have seen consistent inflow. We see this asset growth coming mostly from investors who were initially invested in hedge funds, that applied similar strategies but in a more expensive and less transparent way, and were disappointed about performances in combination with a substantial cost base.
With the growing popularity of factors we do see a lot of offerings appear that use more complex approaches. We believe one should be wary of such complex and less transparent strategies as these are more subject to data-mining risk and thereby often show inferior performance out of sample.
What if a factor stops working?
Stan: The existence of factors has been extensively researched, proven by academics and applied by practitioners. Behavioural biases are one of the drivers behind the existence of factors and we know that a bias doesn’t shift easily. Because investors have different objectives, this creates structural opportunities that can be captured using a factor-based approach.
To what extent is factor investing commoditised?
Willem: Factor investing within equities has matured but we clearly see this isn’t the case for multi asset, multi factor absolute return offerings. Within that spectrum of factor investing we have seen consistent inflow. We see this asset growth coming mostly from investors who were initially invested in hedge funds, that applied similar strategies but in a more expensive and less transparent way, and were disappointed about performances in combination with a substantial cost base.
With the growing popularity of factors we do see a lot of offerings appear that use more complex approaches. We believe one should be wary of such complex and less transparent strategies as these are more subject to data-mining risk and thereby often show inferior performance out of sample.
Source: (1) Harvey, C.R., Y. Liu, H. Zhu, 2015, …and the Cross-Section of Expected Returns, Review of Financial Studies:5-68
Willem: First, build a strong understanding of why factors exist and why they deliver attractive diversifying returns. Then, see how they are put into practice. Is there a disciplined research and execution process? How does one control the risk of data-mining or
p-hacking? How robust, efficient and scalable is the platform used to perform the research and implement the strategies? And do not simply select based on superior back-test results. The combination of simplicity, transparency in terms of process and infrastructure, and “live” performance are the important elements to assess.
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Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
Simple, intuitive and effective: avoiding the
data mining trap
By Natixis Investment Managers
New adventures in alternatives
Navigating market turbulence in 2019 calls for the construction of flexible, diversified portfolios. Alternative strategies can provide a different lens through which to view market volatility and the potential risk and returns, explains Darren Pilbeam, UK Head of Sales at Natixis Investment Managers
New adventures
in alternatives
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We know that alternative investments are becoming increasingly popular with financial advisers and wealth managers, with seven in ten saying they have become essential for portfolio diversification (Natixis Professional Fund Buyers Survey 2018).
Alternative strategies have the potential to boost portfolio diversification, which can help to counteract the risk that poor performance by any single asset class or investment strategy might pose to a portfolio’s overall health. They are also designed to have a low correlation to stocks and bonds, so they move independently of how these assets might behave in other market conditions.
These characteristics ultimately result in a reduction of portfolio risk, dampening the negative effects of market volatility if and when it occurs. In addition, alternative strategies can also help amplify portfolio returns by providing investors with new sources of performance that can be generated often irrespectively of the broader market backdrop.
In short, alternative investments help to de-correlate and diversify portfolios while dampening the impact of volatility. And, given the bumpy investment landscape of 2019, it’s perhaps easy to see why most investors are planning to allocate more of their portfolios to alternatives in both the short and the long term.
A QUESTION OF RISK VERSUS RETURN
Alternative investments fall into two broad categories: liquid or illiquid. Illiquid strategies tend to have higher return prospects but require investor capital to be locked up for longer periods, often over a decade. This is commonly referred to as ‘the illiquidity premium’.
Examples of illiquid alternatives include private equity and hedge funds, which generally impose limits on withdrawals. They also include tangible or ‘real’ assets, like real estate and infrastructure.
Real assets can typically provide downside protection – as illiquid asset pricing typically lags behind public market asset pricing – and can offer portfolio diversification. What’s more, there are predictable cash flows, which can be inflation-linked for the duration of a long-term contract. However, the relative ease of valuation and ability to transact, as well as the potential difficulty in finding buyers and sellers, are all factors that contribute to the asset’s illiquidity.
Liquid alternatives, as the name implies, can be more readily exchanged or sold than illiquids. Strategies include managed futures, global macro, long-short equity and absolute return. The tendency is to focus on absolute returns – exploiting arbitrage opportunities or focusing on relative value strategies – that enables them to generate returns irrespective of the overall direction of markets.
Liquid strategies can take many forms:
THE LONG AND SHORT OF IT
So there’s clearly a diverse range of alternative strategies available across the risk-return spectrum. These strategies can employ a number of additional tools that can help improve diversification, risk management and potential returns – including short positions, leverage, relative value, illiquidity and complexity.
This means investors can really hone in on the strategy that best suits their portfolio from a risk, return and diversification perspective. As a result, while many of the liquid strategies – such as equity long-short or global macro – were considered an expensive and exotic delicacy for advisers not long ago, it is not necessarily the case today. Moreover, their increasing availability on platforms mean they’re easy to add to client portfolios.
As one of the world’s leading multi-affiliate asset managers, Natixis Investment Managers can offer a wide spectrum of liquid and illiquid strategies, spanning investment vehicles that can range from UCITS funds to managed accounts. And several of our affiliates run both traditional and alternative strategies.
AlphaSimplex Group (ASG), for instance, runs long-only asset allocation strategies, and is also active in managed futures, trend-following commodity trading advisors (CTAs) and alternative risk premia strategies. ASG’s alternative UCITS funds are designed to adapt to changing market dynamics. Investors can gain exposure to global equity, fixed income and currency markets with indirect exposure to commodity markets. They also have the flexibility to hold both ‘long’ and ‘short’ positions in each asset class to benefit from long and short prices.
Another of our affiliates, DNCA, manages both long only equity and equity market neutral strategies. Meanwhile, Ostrum manages traditional equity and credit strategies, and also private debt in areas including infrastructure, aerospace, leveraged loans, and structured credit. Another, Seeyond, runs low-volatility long only equity and alternative equity-volatility strategies.
NO LONGER AN EXOTIC DELICACY
It’s only right and transparent to mention, of course, that many multi-asset portfolios simply didn’t deliver the promised diversification benefits in 2018. Indeed, the latest Natixis Global Portfolio Barometer revealed that many liquid alternatives – particularly managed futures – underperformed against expectations last year.
But the other way to look at this is that the overall allocation of liquid alternatives in 2018 portfolios was low compared to the allocations to traditional asset classes, like equites and bonds. In many cases, liquid alternatives did provide diversification – there just wasn’t enough of the portfolio allocated to them.
Natixis’ recent survey of global financial institutions (GFIs) found that while return expectations for alternative investments in 2019 have fallen compared to last year, the conviction of GFIs in the asset class has risen when compared to their conviction in equity and fixed income investments – 14 out of the 20 GFIs surveyed were overweight on alternatives for 2019.
The fact is that not all alternatives fund managers underperformed in 2018 – managing alternative strategies isn’t a straightforward endeavour. Financial professionals therefore need to do their homework to find those managers who genuinely deliver value for money.
Value for money in the unpredictable investment landscape of 2019 means finding truly diversified portfolios – those that go beyond the traditional 60/40 split of equities and bonds, and allocate more to liquid alternative strategies that are managed by experienced teams with proven pedigree.
If the world’s top private banks are tilting their allocations towards alternatives in 2019, there’s no good reason why UK advisers shouldn’t send more of their client’s money in the same direction.
TRULY DIVERSIFIED PORTFOLIOS
growth to an unsynchronized slowdown across regions. The fourth quarter of 2018, in particular, saw global equities fall by almost 13% – the Nasdaq was technically in bear market territory on 24 December, down 23% from its end-August peak. December was the worst month for US equities in 50 years.
With interest rates rising, central banks reducing their stimulus and market volatility increasing, 2019 is shaping up to be a complex and challenging investment landscape. Traditional asset classes like equities and bonds certainly still have their place in portfolios, but there’s an increasing need to think outside the box and look at the alternatives.
he traditional 60/40 equity and bond portfolio came under increasing pressure in 2018. This was especially the case during periods of market stress, such as in February 2018, when both asset classes declined sharply in unison.
Meanwhile, the second half of 2018 saw a shift from synchronized global
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Global macro strategies can build portfolios around planet-scale trends and events
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Global macro builds portfolios around predictions of large-scale events on the individual country, region or global scale. They implement opportunistic investment strategies to capitalise on macroeconomic and geopolitical trends.
Long-short strategies, as the name implies, can take long (buying a holding) or short (borrowing a stock you don’t own and selling it in the hope of repurchasing it at a lower price before returning to the stock lender) positions in multiple asset classes.
The ratio of holdings to each one is based on their macro-economic projections.
Managed futures strategies make use of leverage and implement price-based and trend-following algorithms to deliver enhanced returns in both rising and falling markets.
On the illiquid side, we launched Flexstone Partners in the second half of 2018, bringing together three existing private equity affiliates: Euro-PE, Caspian Private Equity and Eagle Asia. This gives clients access to primary, secondary and co-investments in the private equity, mezzanine and infrastructure markets.
Indeed, the strategy menu is fluid for all affiliates – and a close dialogue with investors can lead to the creation of new and bespoke solutions. Such was the case in June 2018, when UK-based private debt manager MV Credit become one of our affiliates. Clients told us they were seeking new sources of diversification and we identified that we had a strategic gap in private corporate debt.
Since 2000, MV Credit has built up one of the largest and most stable teams specialising in European credit, with a strong reputation, and good access to opportunities. When banks and brokers are reaching out to private equity funds to finance loans, they seek MV Credit’s view on the pricing and structure of deals. And, crucially, the firm has performed well through several credit cycles.
In terms of real assets, we have AEW. AEW UK’s real estate team is one of the most experienced in the industry – one reason why it was awarded a UK pension fund mandate for £450 million in 2018.
Likewise, on the infrastructure side we have sustainable investor Mirova. It’s primarily through this affiliate that we are a recognised leader in environmental, social and governance (ESG) investing.
FLUID ON ILLIQUID STRATEGIES TOO
Yet, in the UK market, our most well-known affiliate in the alternatives space is H20 Asset Management. This £20.8 billion firm specialises in global macro strategies and offers individual investors a range of absolute and total return UCITS.
Investing primarily in global debt, currency and equity markets, their range of funds have been hugely popular among European investors and fund selectors – some of the funds have produced five-year annualised returns of 20% or more. The firm has a strong team that has worked together for decades. It takes a high conviction approach, has one of the best track records in discretionary global macro, and its portfolio managers are resilient money managers with strong macro trading experience.
What’s more, there are new strategies from H20 coming into view in 2019. Systematic investment opportunities are now available through its affiliate, Arctic Blue (see box out), while lower volatility varieties of its popular MultiReturns strategy are also on the near-term horizon.
BEYOND GLOBAL MACRO
Tap here to find out more about the alternatives range at Natixis Investment Managers
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Arctic Blue Capital is an affiliate of H20 Asset Management and generally considered to be its systematic investing division. Systematic equity strategies seek to capture periods of rising volatility and use the directional momentum to create opportunities for positive returns. It’s a useful play when you consider the uncertainty created for equity market investors as a result of volatility returning to markets in 2018.
Arctic Blue’s strategies take a contrarian bias, meaning they identify when a trend begins to weaken and gradually initiates positions in the opposite direction, before the trend reverses. It’s an idea that comes from observing the behaviour of discretionary traders, extracting the best of their rules and, essentially, turning that behaviour into a system or code. In this way, the strategies seek to overcome the natural biases and flaws of human traders and only trade when the market environment is favourable.
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ALTERNATIVES
New adventures in alternatives
Simple, intuitive and effective: avoiding the data mining trap
Alternatives today: providing value in the current market
New adventures in alternatives
Simple, intuitive and effective: avoiding the data mining trap
Alternatives today: providing value in the current market
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Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
By Natixis Investment Managers
Simple, intuitive and effective: avoiding the
data mining trap
New adventures in alternatives
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attractive risk-return profiles to working hard as a kind of insurance policy. Today many investors have recognised that a sizable allocation to alternatives can give a needed boost to portfolios. AJ Somal, a financial adviser at Aurora Financial Planning, says that among this clients: “There has been a shift to investing in alternative assets, and a move away from traditional asset classes like bonds and equities.”
He adds: “My clients have been investing in property (buy-to-let), peer-to-peer lending, and buying premium bonds – with the latter to mitigate tax.”
The alternative funds chosen for a portfolio depend on the role they are expected to play and how granular a portfolio manager’s fund selection and asset allocation are. Do they sit in an ‘alternatives’ allocation? Are they included under a ‘diversification’ heading? If they are more directional, do they actually sit in a portfolio’s equity risk budget?
he traditional 60/40 equity and bond portfolio came under increasing pressure in 2018. This was especially the case during periods of market
T
Global macro strategies can build portfolios around planet-scale trends and events
READ MORE
Turning traders into code
READ MORE
Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
Simple, intuitive and effective: avoiding the
data mining trap
By Natixis Investment Managers
New adventures in alternatives
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Turning traders into code
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Alternatives today:
providing value in the current market
A report by Investment Week
By NN Investment Partners
Simple, intuitive and effective: avoiding the
data mining trap
By Natixis Investment Managers
New adventures in alternatives
SECTOR REVIEW
ALTERNATIVES
