When the $1 trillion Norwegian government sovereign fund lost almost a quarter of its value in the financial crisis, it turned not to passive managers but to factor funds.
The fund’s absolute performance in the decade between the crisis and today has been better when compared with the preceding decade.
This moment was a real watershed for the investment industry – so it’s worth looking at the detail.
Stung by the losses, and a national parliament anxious for answers, the Norwegian Ministry of Finance commissioned academics to analyse the fund’s active returns – that’s actual returns minus the benchmark – to see what their internal and 200-odd external active fund managers were doing for them.
They found that active fund managers added less than 1 per cent of overall returns, with the benchmark doing the rest .
But they also found that this modest contribution could be mostly explained by a small number of systematic factors, not least value, liquidity and volatility. These weren’t deliberate choices by the client – but were by-products of the way the fund managers worked.
The academics recommended that the Ministry of Finance (which set the benchmark) should actively decide the level of factor exposure and that these exposures should be included in the benchmark .
And that’s factor investing in a nutshell.
It’s based on decades of academic research which says a number of investment factors can offer higher returns and better diversification than the traditional indices used for fund benchmarks. And this mode of investing usually comes at a lower fee level than active management.
Today, it’s widely accepted that there are five factors:
• Value – where the price of an investment is cheap compared to its fundamentals.
• Momentum – the tendency of securities to continue to perform as they have previously, whether good or bad.
• Quality – which means ‘better’ companies (measured by profitability and other metrics) outperform lower quality companies.
• Low-volatility – some shares or bonds respond to market shocks more modestly than others, and therefore offer high returns over the long run.
• Size – smaller companies tend to outperform larger ones, not least because they are under researched and, in many cases, overlooked by the very large institutional investors.
As you might expect, we’re fans of factor investment and made our first investment last year – into a fund also intended to achieve our goal of significant reductions in our exposure to fossil fuels. We have a number of reasons.
One is their provenance. Unlike many new ideas, which originate from fund management companies and turn out to be fads, this comes from the client side and has a vast body of academic literature behind it.
Another is the enhancement to the risk/ return profile. We added factor investments to our default strategy and, while one year is far too short a time to assess their usefulness, we would expect them to play a notable role in achieving our target of beating inflation over the coming decades.
We also like the low fees. At The People’s Pension, a master trust workplace pension recently granted authorisation by The Pensions Regulator, we aim to keep member charges as low as possible. Factor funds can offer better returns than passive investments, without the sometimes excessive fees for actively managed funds.
The other reason is time. We have a very long investment time horizon whereas markets have an increasingly short one. This means market movements are dominated by short- term factors and noise, not long-term information. Factors funds appear to have a better long-term risk and return payoff to us, so offer us a more effective way of delivering for members over the decades.
Time will tell if we’re right – but we’re greatly encouraged by a decade of Norwegian experience and, more importantly, decades of academic research.