June 27, 2017 / 12:17 PM / 5 months ago

DERIVATIVES-Factors make multi-asset shift

LONDON, June 27 (IFR) - Multi-asset risk factor strategies have dramatically outperformed traditional investments through the volatile macro environment of the last 12 months, accelerating expansion of the factor-based approach beyond its equity roots.

Attempts to replicate hedge fund returns by allocating to alternative sources of beta, such as momentum, value, volatility and quality, has become almost mainstream in equity investments since Danish pension fund PKA applied the approach to its entire equity portfolio in 2012.

Around US$500bn is invested in equity risk factor funds, but investors are finding the diversification benefits to be amplified by applying the strategy on a cross-asset basis.

“I think it’s a logical next step,” said Stan Verhoeven, co-lead portfolio manager for multi-asset factor investing at NN Investment Partners. “If you believe in the drivers behind factor investing and the drivers behind the return, which is a reward for risk based on behavioural biases or as a result of market structure, they extend to all asset classes so it makes sense if you apply it in multiple asset classes.”

The investment firm has attracted US$125m to its Multi Asset Factor Opportunities fund since launch in February 2016. The fund allocates to value, carry, momentum, flow and volatility factors across equity, fixed income, FX and commodities.

The fund has returned 16.4% on an annualised basis since inception, with all factors positively contributing, outperforming a traditional 60/40 bond/equity split that returned 10.21%.

“It’s really a true diversifier and less exposed to major market events than standard equity and fixed income investments,” said Verhoeven. “We had strong performance during the weeks before Brexit and all subsequent weeks after as you benefit from other sources of return that are driven by other return drivers.”

MSCI World outperformed the strategy over the same period, delivering more than 17% on an annualised basis but with higher volatility and a larger maximum drawdown.

Gains in the multi-asset factor fund were concentrated in the two months around the Brexit vote - a period when MSCI World and Barclays Global Aggregate bond index were little changed. Verhoeven puts that down to the diversification, which can drive performance over short periods compared to equity-only factors that target long-term performance given periods of underperformance that can last for multiple years.

“Each individual factor should perform over the long term, but if you combine uncorrelated factors properly there’s a huge diversification benefit that can provide very attractive returns in a shorter timeframe,” said Verhoeven. “That’s truly the power of factor investing.”

Based on indices rather than single stocks, the fund invests in liquid derivatives such as futures on 10-year government bonds and futures on 22 commodities included in the Bloomberg Commodity Index.

While factors exist across all asset classes, funds typically have limitations due to liquidity constraints. The flow factor, for example is only applied to equity and commodities in the NN fund, given the high transaction costs associated with a short-term reversal strategy.

Volatility is offered only in equities as the strategy, which sees investors go structurally short VIX futures, can only be replicated across other asset classes though the index options market, requiring regular delta hedging that can be costly and operationally cumbersome.

“When an event happens, volatility tends to jump up in all asset classes and you lose money across all asset classes, so we’re still discussing whether the costs outweigh the diversification benefit,” said Verhoeven.

The fund has a total capacity of around US$2.5bn without any material changes, according to Verhoeven. That is limited by liquidity in fixed income futures and less liquid commodities such as lean hogs. Any increase above that would require scaling back in less liquid markets, and a shift into the more liquid over-the-counter swaps market for fixed income investments. (Reporting by Helen Bartholomew)

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