A Skeptical Look at Risk-Factor Investing Research

Faulty study design accounts for much of the evidence that risk-factor investing is superior to asset class models, according to two prominent managers.

(July 11, 2013) – Risk-factor models routinely outperform asset class-based portfolios in academic studies, but according to a new article, superior optimization often isn’t the reason why.

Rather, these theoretical factor-based portfolios may win out thanks to investment constraints hindering model asset class portfolios. Thomas Idzorek, CIO of Morningstar Investment Management, and Maciej Kowara, research director at Transamerica Asset Management, contended that studies often compare simple, long-only strategies to risk-based models that are allowed to go short and pursue niche assets.

“Most such [pro-risk factor] papers use apples-to-oranges comparisons that lead all but the most careful reader to believe that risk-factor-based asset allocation is inherently superior to allocation based on asset classes,” Kowara and Idzorek wrote in the Financial Analysts Journal article. “In some cases, the apparent superiority of the risk factors is a simple result of the fact that the risk factors are, in a guise, a set of asset classes with the long-only constraint removed.”

One of the studies cited by the asset managers—”Portfolio of Risk Premia: A New Approach to Diversification,” a 2009 MSCI paper—uses a two-index 60/40 portfolio of developed market equities and US investment-grade bonds as its traditional strategy. The risk premia model includes 15 factors represented by 11 indices across long and short positions.

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Between May 1995 and October 2008, the asset class portfolio would have earned 2.2% annualized above the risk-free rate, with a maximum drawdown of -30.6%. The risk premia approach would have gained 2.7% in excess returns while its steepest drawdown was -11.8%.

Amid their critique of the field’s research methodologies, Kowara and Idzorek are adamant that they are not against risk-aware investing. “We applaud the innovation of using risk factors in the asset allocation process,” they wrote. “Positive messages from these papers with which we agree are that relaxing the long-only investment constraint and expanding one’s opportunity set to include more potential exposures are often good things.”

Based on their own self-proclaimed “apples-to-apples” study of the two strategies over the 1979 to 2011 period, risk factors are neither a better nor worse way to structure a portfolio than asset classes: “If one truly creates an even playing field, there is no gain in efficiency.”

The industry has no standard set of portfolio risk factors. Still, based on the perspective of one leader in the field, Columbia Business School’s Andrew Ang, the long-only 60/40 “asset class” model described above is also a factor portfolio—just a very, very simple one: “Some risk factors are themselves asset classes, like plain-vanilla stocks and bonds,” Ang said in a working paper published last month. “These are passive factors earned by simply going long the equity or bond market.”

Thomas Idzorek and Maciej Kowara’s “Factor-Based Asset Allocation vs. Asset-Class-Based Allocation” is available in its entirety here.

(July 11, 2013) — Last year saw institutional investors take flight towards the biggest asset management brands of asset managers, with almost all of the net new inflows going to the top 10 asset managers.

The trend, spotted by the Boston Consulting Group (BCG) in its 11^th annual worldwide study of the asset management industry, was most pronounced in the US, where 94% of all net new fund asset flows were captured by America’s top 10 managers.

In Europe, the push towards the top players was less intense, with just 51% of net new fund inflows going to their top 10 managers.

Drilling down further, US investors placed 73% of their active core strategy mutual fund assets in the hands of those same top 10, along with 65% of their core equity strategies assets. That ratio reached 76% for fixed income specialties, 72% for core fixed income and 72% for other specialties, such as commodities or private equity.

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In Europe, although the overall trend was less pronounced, there was a drive towards the bigger asset managers for specialties–56% of new assets in fixed income specialties went to the top 10 managers, alongside 49% of other specialties.

Globally, the asset management industry achieved substantial growth after four years of relative stagnation, the report said, surpassing the pre-crisis level for the first time with a grand total of $62.4 trillion.

Of that, $30.3 trillion was in North America, $17.5 trillion in Europe and $6.3 trillion in Japan and Australia. The rest of Asia totaled $3.8 trillion, South Africa and the Middle East reached $1.2 trillion and Latin America amassed $1.5 trillion.

A second trend BCG spotted was what it called a “structural shift” in how institutions are investing: actively managed core assets are out; fixed income, specialties, such as emerging market asset classes, and what BCG called “solutions”, such as target date funds, are in.

According to the report, a quarter of managers globally experienced significant erosion of their actively managed core asset base in 2012. The problem was particularly noticeable in Europe, where 30% of managers lost 5% or more of their active core assets through net outflows.

The money flowed into solutions, specialties, passive, and alternative products–and BCG predicted that trend will continue.

In both the US and Europe, the top 10 strategies included target date funds, emerging market equities, emerging market bonds, high yield bonds, and global funds.

“In this competitive environment, many traditional asset managers have little choice but to try and identify specific areas in which they can build more relevant capabilities,” the report warned.

“The threat looms particularly large for managers in continental Europe and Asia Pacific. There, due to the smaller presence of pension funds and endowment businesses, specialties did not develop as much as in the US or the UK markets: they weren’t as relevant to mass-retail investors or insurance companies, or other institutions with restrictive investment guidelines.”

And those European and Asia Pacific managers will now find it hard to gain a foothold in specialist markets, as the gap has allowed US and UK managers to expand into their regions.

Will this trend continue into 2013? Only time will tell. The full BCG report can be read here.