NORTH- WEST UNIVERSITY INVESTING IN SYSTEMATIC FACTORS BWIN 816 – Modern Portfolio Theory

BWIN 816 – Modern Portfolio Theory R. Yacumakis 21277087 1 Page 10

BWIN 816 Ruan Yacumakis

21277087 27 June 2014

NORTH-WEST

UNIVERSITY INVESTING IN SYSTEMATIC FACTORS

BWIN 816 – Modern Portfolio Theory R. Yacumakis 21277087 Page 1

Table of Contents

1 INTRODUCTION ....................................................................................................................................... 2

2 A DESCRIPTION OF FACTOR INVESTING ................................................................................................... 3

2.1 CHARACTERISTICS OF A GOOD SYSTEMATIC FACTOR ........................................................................................... 3

2.1.1 Underpinning of the factors .............................................................................................................. 3

2.1.2 Criteria for a systematic factor ......................................................................................................... 4

2.2 COMMON FACTORS AND FACTOR CLASSIFICATIONS ........................................................................................... 5

2.2.1 Factor premium categories ............................................................................................................... 5

2.2.2 A list of available factors ................................................................................................................... 6

2.3 APPLICATION OF FACTOR INVESTING ............................................................................................................... 8

2.3.1 Benchmark portfolios that are passive but dynamic ........................................................................ 8

2.3.2 Three models used to implement factor investing ............................................................................ 9

3 TOPICAL CONSIDERATIONS FOR INVESTING IN SYSTEMATIC FACTORS .................................................. 10

3.1 GAIN UNDERSTANDING AND CONTROL OF PORTFOLIO FACTORS – NORWAY ......................................................... 10

3.2 DYNAMIC FACTORS AND BAD TIMES ............................................................................................................. 11

3.3 FACTOR SELECTION VS SECURITY SELECTION IN LARGE PORTFOLIOS ..................................................................... 12

3.4 TOTAL PORTFOLIO APPROACH .................................................................................................................... 13

3.5 INVESTABILITY ......................................................................................................................................... 14

3.6 LIQUIDITY OF ASSETS ................................................................................................................................. 14

3.7 WEIGHTING ............................................................................................................................................ 14

3.8 MACRO FACTOR INVESTING ....................................................................................................................... 15

4 VIABILITY OF FACTOR INVESTING IN SOUTH AFRICA – A CHECKLIST APPROACH .................................... 15

4.1 INDIVIDUAL INVESTOR VIABILITY CHECKLIST ................................................................................................... 15

4.2 COUNTRY CHECKLIST................................................................................................................................. 17

5 CONCLUSION ......................................................................................................................................... 18

6 REFERENCES .......................................................................................................................................... 19


1 Introduction

In the world of investments, benchmark portfolios are used in setting up investment strategies

(Norwegian Ministry of Finance (NMF), 2013). Standard asset allocation methodology involves the

fund owner deciding on the weightings of available asset classes according to his risk-return

preferences, and then combining these asset weightings into a strategic benchmark portfolio (Ang,

2013). The task of the fund manager is then to invest in these asset classes according to the specified

weightings and other limitations set by the fund owner. Passive management would entail investing

in the benchmark portfolio via market capitalisation weighted indices within each asset class. This

would produce the so-called market return within each asset class, and the portfolio return would

simply be the asset weighted aggregation of the market returns. Active investment management on

the other hand, would entail the fund manager applying non-market weightings within the asset

classes based on his expert market readings and predictions. The goal of this approach is to obtain

returns in excess of the market returns after deducting for the relatively high active management

fees. (Ang, 2013; Koedijk, Slager & Stork, 2013; NMF, 2013)

In recent years, increased attention has been given to an alternative investment approach that does

not primarily weigh the portfolio according to asset classes, but rather using so-called systematic

factors. The basic idea behind factor investing is as follows: (note that stocks will be considered for

illustrative purposes, but the concept applies to other asset classes as well; although the necessary

data for other asset classes such as real estate might not be as readily available). Systematic factors

are different characteristics that influence stock values over time. Statistical analysis shows that the

bulk of stock price variation can be explained by no more than ten factors (NMF, 2013). If these

factors can be identified and measured in some way, an investor could hold specific weightings of

stocks that would make him insensitive to some of these factors and heavily geared towards the

movement of others. Tilting investments toward factors in this way is called factor investing, and it

has been proven to increase returns over time as opposed to holding market weightings (NMF,

2013). Tracking systematic factors is not a new concept, the theory has been around for decades.

However, the idea of investment allocation decisions based on systematic factors per se only

recently gained attention (Koedijk et al, 2013).

The goal of this essay is to describe the fundamentals of this investment approach and to present a

tool to help fund owners and managers in South Africa determine if using this approach is a good

one in their fund- and country-specific context.


The focus of this paper will therefore be more on determining the viability of investing in systematic

factors and less on the mechanics of applying it, although the latter will briefly be looked at. The rest

of this essay is structured as follows: Section 2 introduces the basic concepts of systematic factors by

looking at how they are identified, which ones are currently popular, and how they can be used in

the investment process. Section 3 then considers the most relevant topical issues to take cognisance

of when considering using a factor investment approach. Section 4 then summarizes these matters

into a checklist that fund managers can use to determine the viability of investing in systematic

factors in the South-African context. Firstly a checklist is composed to help stakeholders determine

whether their specific fund is properly suited for factor investing according to its basic characteristics

such as mandate, size, risk appetite and other salient characteristics. Secondly, the South African

markets are evaluated against a country-wide checklist to determine whether it is advisable to

pursue factor investing in these markets, given that the specific fund is correctly positioned for it.

Section 5 concludes the paper.

2 A Description of Factor Investing

This section will develop the idea of factor investing by firstly looking at the basic criteria for a factor

to be consider a good factor to use, secondly listing the most popular factors that fulfil these criteria,

and finally giving a condensed description of how factors can be implemented in investments.

2.1 Characteristics of a good systematic factor

Firstly, an overview of important research in this field is hereby considered.

2.1.1 Underpinning of the factors

According to the Norwegian Ministry of Finance (2013), research on the underpinning of systematic

factors has brought these important points to the fore:

There are factors that have been thoroughly researched over different time periods and in

different markets and they’ve proven to consistently give above-market average returns.

Such factors are robust and preferable. The important question to ask is whether these

trends of increased returns will continue into the future.

The reasons as to why these factors yield such return premiums are not clear, and different

factors have divergent rationalizations. Some explanations include:

o Increased risk offers increased return.


o Behavioural models can also explain these factors: Investors often act in non-

rational ways; hold on to old paradigms, thoughts or opinions for too long and

misjudge probabilities.

o Agency factors can also play a role.

The topic of systematic factors is an active research field, therefore stakeholders should stay

up to date with developments to avoid using outdated and incomplete information in their

operations.

Systematic factors are exploited in a competitive environment by focusing on the special

qualities or characteristics of a specific investor which enable him to harvest suitable factors

better than the average investor can. It is therefore important for an investor to be aware of

and utilise his inherent advantage. For example, an investor with a very long term outlook

can endure short term underperformance from factors. A model case of such an investor is

the Norwegian Pension Fund, as discussed in greater detail later.

Benchmark returns (passive returns) are the result of the asset allocation decision, taken by

the fund owner. Active returns are the result of the decisions taken by the fund manager to

deviate from the benchmark. Their sum leads to the total fund return. Research has shown

that 90% of the variance in return is historically caused by the asset allocation decision.

Equity and bond market returns form the most basic factors available to investors, and they

can easily and cheaply be invested in via passive index tracking funds. The way a fund invests

in these two factors is the most important factor decision taken by funds (Ang, 2013).

2.1.2 Criteria for a systematic factor

Out of the body of research on these factors, several key criteria exist that help identify a robust

systematic factor from which factor premiums ca be harvested. These criteria, as described by Ang

(2013) and Koedijk et al (2013) are now listed. A systematic factor should:

Be justified by academic research.

We must understand why the factor premiums arise as they do. Sound reasoning and historic data

should be used to support the implementation of a factor. Research in this area would allow the

discovery, validation, or discrediting of factors for use in the benchmark portfolio.


Yield large premiums that are expected to persist in future.

Economists should be confident that the factors will still be influential in the near future. This will be

the case when the underlying behavioural patterns that cause them are believed to continue, at

least in the short term.

Historical data for bad times should be available.

For the purpose of knowing what to expect should the market turn downwards, it is important to

know how the factors perform in such bad times. Therefore sufficient return history should be

available for the chosen factors to allow accurate calculation of risk-adjusted returns. The fact that

investors can weather such bad times is the reason that they receive the factor premiums in the first

place.

Factors should be investable via liquid instruments that can be readily traded.

To make these strategies as cheap as possible, trading in relevant securities should be very cheap.

Another important factor for large institutions is whether the positions are scalable to their size (this

concept is discussed further in Section 3). Furthermore, if the negative or opposite side of the factor

can be shorted (eg. long value, short growth), it would lead to greater profits. However, if it isn’t

possible to short the necessary positions, the factor strategy would still reap premiums albeit not as

large.

These factors are dynamic, in that they change over time. Therefore it is very important for ongoing

research to be conducted on the definition of optimal systematic factors. Furthermore, statistical

analysis has suggested that 10 factors can usually capture most variation in return data. However, it

is not advisable to use so many for the sake of simplicity. A select few to cheaply include in a fund’s

benchmark would be the best route to take, according to NMF (2013).

2.2 Common factors and factor classifications

This subsection will list the most common factors and their classification.

2.2.1 Factor premium categories

Factors premiums can be classified in different ways, as described by Koedijk et al (2013) and

summarised below:


Asset class

The more traditional way of allocating risk exposure. Factors in this classification include the

riskiness derived from passively investing in equities, bonds, real estate and commodities.

Style

Style premiums are harvested due to fundamental or technical differences in returns within asset

classes. These factor premiums have been harvested for many years, although they have only

recently been called that. The list in the following subsection mainly composes style factors. They

are also often called dynamic factors, for reasons discussed later in the paper.

Strategy

This type of factor premium is harvested by applying different strategies such as carry, merger

arbitrage or convertible arbitrage. These factors are not discussed in this essay.

Global market factors

Different premiums can also be harvested from investing in geographically diverse locations due to

their relative attractiveness.

Macro factors

Although more difficult to invest in directly, factors such as inflation and economic growth can also

yield premiums. This is discussed in greater detail in Section 3.

2.2.2 A list of available factors

The types of factor premiums are now described and mention is made of the asset classes they apply

to (this list is compiled from NMF, 2013; Ang, 2013 and Koedijk et al, 2013):

Value-Growth – equities, bonds, currencies, commodities

A factor premium is often received from buying securities with a market price that is lower than the

underlying fundamental book value thereof. Growth securities on the other hand show strong share

prices in relation to their underlying book value. A factor premium has existed in the long run for

buying value securities and selling growth securities.

Momentum – equities, bonds, currencies, commodities

Securities that have shown impressive growth in price during recent times are overweighed to

produce a momentum premium. This factor, maybe more than any other, can be ascribed to


behavioural models since the market is overoptimistic about a certain security due to past

performance and therefore demand for it grows. The converse can also be true for securities with

prices that are consistently falling.

Low volatility – equities, commodities

Securities with low price volatility are preferable since they impose less risk on investors. Therefore,

their prices tend to grow faster than stocks that are highly volatile. Investing in low volatility

securities yields an interesting factor premium, since the investor is compensated not for taking on

more risk, but actually the converse.

Liquidity – equities, bonds

According to NMF (2013), there are four ways to profit from liquidity premiums and liquidity risk

premiums:

When the market slumps, buy securities with a high liquidity premium.

Passively invest in a characteristically low-liquidity asset class, such as unlisted real-estate.

Within an asset class, go long in the least liquid instruments in the market and short in the

most liquid ones. Thus the premium is received without being exposed to the market factor.

Provide in the liquidity needs of the market by presenting liquidity for substantial bond and

stock holdings (this is called acting as a market maker).

Size – equities

Smaller companies have a larger risk of going bust, and therefore yield a higher return to

compensate for this. Therefore a size premium (also called small cap premium) can be harvested by

overweighing small companies and cutting back on large ones. A factor premium can also be

obtained from investing in the emerging equity market, i.e. the unlisted space.

Term spread – bonds

This premium is harvested when long-term bonds are overweighed relative to short term bonds.

Long term bonds have greater volatility, and therefore greater risk, resulting in the factor premium.


Credit – bonds

The difference between returns of safer and less safe bonds also produce a premium. The premium

compensates the investor for taking on credit risk. An example is the difference between returns on

a corporate bond and returns on a risk-free government bond.

Convexity – bonds

Bonds with higher convexity have also received factor premiums historically, although this type of

premium is not commonly used.

Other

Anomaly factors also exist, including calendar effects, IPO-anomaly, index change anomaly and the

accruals anomaly. These factors are not so common in the literature, and will not be discussed in this

paper.

2.3 Application of factor investing

2.3.1 Benchmark portfolios that are passive but dynamic

One way to apply factor investing is for a fund to use a passive, dynamic benchmark portfolio in the

investment strategy. An investor would choose a passive strategy for investing in systematic factors,

such as 5% preference towards value vs growth, 10% preference towards low-volatility vs high-

volatility and 5% toward momentum vs non-momentum securities. The portfolio is constructed with

non-market weights in accordance to the specified preferences. However, the shares that are

defined as value/growth, low/high-volatility or momentum/non-momentum shares might change

over time as their prices fluctuate according to market sentiment, leading to necessitated

rebalancing to reflect such changes. This is an illustration (detailed in Ang, 2013:33) of how

benchmark portfolios can be passive in the rules they specify, but dynamic in their composition over

time. Although index companies offer funds to utilize such an approach, an investor is best advised

to construct a benchmark portfolio that is tailored to his individual characteristics, as discussed in

Section 3 (Ang, 2013).

An important consideration is whether to use active or passive management to capitalize on factor

risk premiums. The question that needs to be answered is whether an active manager can obtain

returns (net of active management fees) in excess of a passively managed market-based index. If

exposure to the risk factors can be utilized more cheaply by investing in a static benchmark portfolio,


then there is no need to pay an active manager obtaining additional alpha that is less than their

costs (Ang, 2013).

Also, it is important to decide on who chooses the factor exposures: The portfolio owner or the

manager? One solution is to delegate short-term decisions to the asset manager, long-term asset

weighting decisions to the owners, with dynamic factor strategies occupying the middle ground. If

the owners are aware of the dynamic factors involved in the portfolio, they would not be angry if

these factors underperform in the short-term, since it is to be expected of such strategies (as

described in Section 3). Clearly defining risk factors contained in the portfolio’s benchmark would

allow investors to commit to such factors in the long run (Ang, 2013).

2.3.2 Three models used to implement factor investing

Three ways to model factor investing are currently used globally. These models describe how to

imbed factor investing into the traditional investment management process so as to attain better

diversification in the portfolio or capitalise on a chosen set of factor premiums. These models are

now described.

Risk due diligence

This model does not change the investment process, but rather seeks to identify areas of

concentrated risk by using the systematic factor approach, especially on the strategic asset

allocation level. Processes such as stress testing and scenario testing are used to help investors gain

insight into the sensitivity of the portfolio to different underlying drivers. Thus an unwanted

concentration of factors can be identified and the portfolio can be better diversified. Factor investing

is therefore not rigorously implemented, but used as an aid to the current process flow (Koedijk et

al, 2014).

Factor tilts

This approach seeks to capitalise on a chosen set of factor premiums within current asset classes by

choosing asset weights in the optimal way. This approach is the most popular since the investment

process stays unchanged, but the return/risk relationship is improved by adding factor premiums to

the strategic asset allocation choice (Koedijk et al, 2014). This approach involves holding non-market

capitalization weightings of assets and creating customized indices, as described in Section 3.


Factor optimization

The factor optimization approach seeks to apply factor across different assets, rather than within

asset types. The whole portfolio is constructed based on factors, and the key challenge is to then

translate factor weightings accurately into asset holdings. This approach is not widely used as of yet

Koedijk et al, 2014).

3 Topical Considerations for Investing in Systematic Factors

3.1 Gain understanding and control of portfolio factors – Norway

The Norwegian Government Pension Fund initiated an investigation into the fund’s active

management after exceptionally bad performance during the 2008-2009 recession. The fund owners

weren’t angry because of the losses incurred by the fund in this period, they understood the risks

involved in investing 60% of the portfolio in stocks. The disgruntlement arose due to the fact that the

active management return component of the fund was negative for the 2008-2009 period. The

Norwegian Ministry of Finance provides a benchmark, and the fund manager, Norges Bank

Investment Manager (NBIM), is then tasked to outperform this benchmark by applying different

weightings than that of the benchmark. Subtracting the return of the benchmark from the return of

the fund gives the active return. If this is not sufficiently large, the money could just as well have

been passively invested in index-tracking portfolios at lower management costs, yielding a higher net

return (Ang, 2013).

A task team was commissioned to investigate the causes of negative active returns and make

recommendations to the Ministry of Finance on the way forward (Koedijk et al, 2013). This report

was quickly dubbed the “Professors Report”, or Ang, Goetzmann and Schaefer (2009). Their findings

showed that systematic factors contributed a large portion of the fund’s performance before, during

and after the financial crisis. Therefore, the fund unwittingly reaped the premiums from investing in

systematic factors (such as value and low volatility); but this was at the cost of being exposed to the

risks that come with these factors. This situation is perfectly permissible, as long as the fund

managers and owners are totally aware and approving of such an approach. In that case the use of

factors in the investment strategy allows greater transparency and control in the dynamic factor

risks that the fund is exposed to beyond the market risk of the generic asset classes. This means that

the investor will take on risks that he is able to stomach and ride out short-run underperformance to

reap factor risk premiums in the long run (Ang, 2013).


However, this should be clearly communicated to stakeholders so that they can expect times of

lower performance from the outset (NMF, 2013).

The report suggested that the fund invests in the liquidity factor (such a pension fund doesn’t need

quick liquidity) and the value factor (neglected by other investors, leading to low prices) (NMF,

2013). It also suggested that such factors be employed via passive management rather than active,

using a top-down approach in dynamic factors (Ang, 2013). Problems with such an approach would

however arise with investability, as detailed in a subsequent subsection.

From the other side, the fund manager NBIM suggested that the investment into systematic factors

be implemented into the operational management of the fund – i.e. include it in the active

management structure. Discretion is important to choose appropriate factors that are investable.

NBIM suggests that the factors should be clearly communicated, but they should not be

incorporated into the benchmark strategic fund level (NMF, 2013). As an alternative, the manager

developed a tool aimed at improving risk adjusted returns, namely an operational reference

portfolio for equities. It is used to tilt the portfolio in the direction of chosen systematic factors,

resulting in higher risk-adjusted returns. Adjusting these operational reference portfolios would then

be a major part of the active management process for NBIM. As at 2012 the fund manager has

already incorporated value and size systematic factors into the operational reference portfolios for

equities (NMF, 2013).

Clearly, a heavy debate exists on whether to apply factor investing on the higher strategic

benchmark level (where passive management would simply apply relevant factor investment at a

low cost); or at the active management level (using tools such as the operational reference portfolio)

to have a manager who is more in control of the factor weightings as he deems appropriate at the

time.

3.2 Dynamic factors and bad times

These factors are dynamic because they’re based on characteristics that change over time. They

perform well in market ups, but very poorly in market slumps. This is however acceptable, as stated

by Ang (2013): “Factor premiums are rewards for investors enduring losses during bad times.” That is

why factor investing, risky as it is, is not for every investor. He has to be able to weather the bad

times to reap his long time reward for factor risk exposure (Ang, 2013).


To appropriately model an investor it is important to identify the bad times he may encounter and

understand how his liabilities, income stream, and loss tolerance aggravates these bad times (this is

done using utility functions) (Ang, 2013).

Mr Market is average investor. You need to clearly define your profile and select the appropriate

factors to invest in and the way to invest in them. The most important characteristic is the way you

define bad times, i.e. your bad outcomes (such as low growth, high volatility, low liquidity). Then,

assess how these bad outcomes align or misalign with bad times as defined by a specific factor, and

choose to invest in those factors which you are most suited to endure; where the bad times don’t

affect you that much. This can be done by asking these 3 questions, according to Ang (2013):

In which ways am I different from average? Comparative advantages and disadvantages. This

will determine which factors and factor investing strategy would suit you best.

How much loss can I tolerate in bad times? For each individual factor, determine your risk

appetite. If the factor were to have excessive negative returns, would you be able to bear it?

If, for a specific factor, you can’t afford any losses, it might be advisable to invest in the

opposite side of the factor.

Rebalancing. The optimal rebalancing execution buys when factors are at their lowest and

sells when they are at their highest. This is called factor timing, and it is only advised to

skilled active managers since many have inaccurately read the market and depleted a fund’s

value by buying high and selling low.

You will apply weightings to reflect your risk appetite, e.g. When assessing capital allocation along

the Capital Allocation Line used in the CAPM model, you might have a larger proportion of the risk-

free asset than the market if you are risk intolerant, and vice versa (Ang, 2013).

The factor portfolios are often constructed in such a way as to be market neutral, i.e. opposite

positions are taken in the opposing factors so as to only harvest the difference in returns of the two

poles. If such short positions are not taken on, the market factor will still be the main driver of

returns, as opposed to the factor premiums (Ang, 2013).

3.3 Factor selection vs security selection in large portfolios

For large portfolios, the vast number of securities that are held (often thousands) nearly eliminate

the advantages of security selection and result in the situation where factors (together with macro-


economic risks) dominate the fund’s performance. This is especially true when the securities are

correlated, so that the net effect is actually that of the factor underlying them. For example: going

long in 1000 value shares and short in 1000 growth shares is actually one big bet on the value factor,

with no effect coming from the equity asset class (ANG, 2013).

The optimal way to then apply factor investing is when investors first choose the factors they want

exposure to and then buy appropriate assets that will allow them to do so. Some assets are indeed

factors in themselves (equities, bonds) but sometimes an asset’s performance can be split into many

different factors. Ang (2013) illustrates this with a flow-diagram mapping different factors giving rise

to the selection of corresponding asset classes all leading to the eventual portfolio return. Seeing it

this way, one factor can be applied using different asset classes. Thus, the investor first needs to

decide on his preferred factor to invest in, and then appropriate it in the cheapest way possible by

holding relevant asset classes (Ang, 2013).

3.4 Total Portfolio Approach

Some fund managers, such as the Canada Pension Plan Investment Board (CPPIB), managing the

Canada Pension Plan, choose their factors to invest in, and then apply asset allocations (straight

forward or complex) to achieve this. The CPPIB for example only invests in the factors stocks and

bonds. The way it does this gets interesting though, for example: The Plan funds a private equity

holding by shorting public equity and bonds so as to eventually only be exposed to the stock factor

of the private firm. Such an approach of setting factor-benchmarks is most appropriate for funds

that need to match liabilities, since they can do this more accurately by funnelling net investment in

the appropriate factors (Ang, 2013).

Therefore, applying a total portfolio approach using a reference portfolio (ex 65% stocks – 35%

bonds) allows the manager to invest in any asset class (such as private equity or real estate) if 1) he

stays within the specified risk limits on a portfolio level, and 2) he believes that it would give him

additional net return over the expenses of doing so (alpha).

The main advantage of such a levered approach (as opposed investing directly according to asset

classes) is that it enables the investor to control the fundamental factor risk exposure and

understand under which circumstances the fund might perform badly, and be prepared for such

occurrences and manage its potential impact. It identifies alpha more accurately.


3.5 Investability

Investability can become a problem for large institutional investors (NMF, 2013). This issue can be

summarised in two parts: 1) Certain situations could arise where the optimal factor investing

strategy dictates buying large ownership stakes in individual companies. This would be unadvisable

to most investment houses, since they specialise in making investment decisions, not directing the

business operations of companies they own. 2) Large trading volumes could result from necessary

rebalancing. This is non-optimal in two ways: Firstly, the trading costs would be inappropriately

large; and more importantly this could be restricted by law for very large companies, since no single

investor is allowed to affect the share price by its individual dealings. The issue of investability and

scalability is very important to keep in mind when considering factor investing (NMF, 2013).

3.6 Liquidity of assets

A liquid asset (as needed for factor investing) is one that is easily tradable, or as stated by NMF

(2013): “if the purchase and sale of large orders can be executed swiftly at a low transaction cost

without appreciable changes to the price as the result of the transactions”. Aspects included in

determining the liquidity of an asset are:

How easy is it to find a counterparty to your transaction?

How high/low will the transaction costs be for executing the necessary trades?

Will the stock price change significantly due to the transactions be executed? If yes, this will

pose problems.

Liquidity premium is the amount received for providing liquidity.

Liquidity risk premium is for when returns fluctuate due to changes in liquidity (liquidities of

risky assets have historically been correlated).

The four ways to profit from liquidity premiums and liquidity risk premiums were mentioned

in Section 2.

3.7 Weighting

Different weighting methodologies exist, such as equal weighting for all stocks, or weighting

according to market value capitalization. Effective weighting is essential in successfully harvesting

risk premiums and capitalizing on the fund’s unique natural advantages (NMF, 2013).


It’s near impossible for large funds to have a purely systematic factor weighting (as opposed to the

vanilla market capitalization weighting) due to abovementioned investability issues. Therefore, they

often rather start out with market value weighting and then slightly tilt the weightings towards

systematic factors to harvest their systematic risk premiums (NMF, 2013).

3.8 Macro Factor Investing

Apart from investing in easily tradable factors such as value or momentum, it is also possible (but

more difficult) to indirectly invest in macro factors such as economic growth, inflation and monetary

policy (interest rates). This can be done by employing different asset classes that are affected by

these macro factors in appropriate ways (see Ang and Ulrich (2012) for an example of a model that

can do this). If you know how an asset reacts to rising or falling times of a macro factor, you can go

long in assets that are positively correlated to the macro factor, and short on those with a negative

correlation. Examples of such strategies being used in practice are those used by the Alaska

Permanent Fund Corporation and the Bridgewater’s All Weather Strategy. Such macro factor

investing looks beyond the traditional view of allocation by asset class labels and invests

proportionately to the desired exposure to macro factors which are in line with the fund’s goals

(Ang, 2013).

4 Viability of Factor Investing in South Africa – A Checklist Approach

To assess the practicality of factor investing in South Africa, we need to consider several issues. The

question needs to be raised as to whether the South African financial markets are conducive to

factor investing. However, this only paints half the picture. If a South African fund owner or manager

is contemplating factor investing, he not only needs to assess the market in which he operates, but

also (perhaps more importantly) weigh up whether his specific fund is practically suited to the use of

factor investing. In this section, a fund-checklist is firstly developed for a fund owner or manager to

assess the suitability of factor investment to his fund. Thereafter, the South-African markets are also

measured against a country-wide checklist to determine if an investor who qualifies for factor

investing is advised to do so in this country.

4.1 Individual Investor Viability Checklist

The first question to ask should be whether the specific fund with its mandate, size, risk appetite and

other salient characteristics is properly suited for investing in systematic factors.


Irrespective of the country in which a fund is situated, the composition of the fund should harmonize

with factor investing. Furthermore, it is important to consider whether such factors can and should

be applied at the benchmark decision level, the active management level, or both. This entails

determining which model discussed in Section 2 will suit the fund the best. The checklist for

determining the viability of factor investing for a specific fund is subsequently given:

I. Communication – What is the level of communication between fund owners and fund

managers? If managers are going to invest in systematic factors, this will most likely entail

times of slumped growth that need to be endured patiently for factor premiums to pay off.

If fund owners do not understand this, they might get agitated and take their money

elsewhere during bad times, which would be the worst possible thing to do. The complexity

of the relevant investment methodologies also plays a role here, and it should be

communicable to the fund owners.

II. Adaptability – If the stakeholders and processes are not ready for change, it might not be

advisable to attempt factor investing before all parties are well educated on the matter. For

a more conservative approach, the risk due diligence model is ideal to increase awareness of

latent systematic factors, while the factor tilts approach is ideal for the fund that is more

innovative and flexible in its strategies and which seeks to capitalise on factor premiums.

III. Size – If a fund is very large, investability issues might arise as discussed in Section 3. A very

large fund might be forced to take on controlling positions in smaller companies if it employs

rigorous factor investing; while a small fund might not be able to take appropriately small

positions cost-effectively.

IV. Time-horizon – Investors who are mainly orientated to the short term should rather steer

clear of factor investing, since factors tend to fall heavily during downturns. Long-term

investors are ideally suited to profit from factor premiums in the long run, albeit with some

short term slumps.

V. Trading costs – If the chosen factor investment style requires regular rebalancing, the

trading costs could become unaffordable. Therefore the fund needs access to relatively low

trading costs to effectively reap net profits from factor premiums.

VI. Liquidity needs – As mentioned in Section 3, funds that invest in the low liquidity factor

should be able to survive for long time periods without requiring excessive amounts of cash.


If a fund consistently needs to make cash payments it might not be ideally suited for factor

investing.

VII. Bad times – Coinciding with some points above, it is important to know how an investor is

affected by bad times in terms of income/liability streams and his ability to absorb losses.

This will determine whether factor investing (which will lead to bad times at some point) is a

viable option to an investor.

4.2 Country Checklist

This subsection discusses whether factor investing is a good approach to use in South Africa overall.

A country checklist for the suitability of factor investing is set forth, and each point is applied to the

South African financial markets to illustrate the suitability of this approach here. The country

checklist is as follows:

I. Relevance – Are the main factors relevant to the country’s financial markets? Little empirical

research exists for South African systematic factors, so it is not certain whether these factors

are relevant in the local context. However, South Africa has a very well-developed market

with a lot of international investors and equities participating, so it is not a huge leap to

assume that the same factors that apply in the USA and Europe apply in South Africa as well.

II. Persistent – Will the factors persist in the future? If the first checkbox can be checked for

South Africa, it would be safe to assume that the behavioural patterns causing the

systematic factors will persist into the future, given that the research is for a substantial

historical period.

III. Data availability – Are there enough historical factor data available for bad times? South

African data are very readily available, this is a definite check.

IV. Instruments – Are there readily tradable, liquid assets that can be used to invest in the

factors? The South African financial markets are deep, liquid and diverse, so this is another

definite check.

V. Regulation – Will the regulator accept factor investing as compliant to the Prudent Investor

Rule (see Koedijk et al, 2013)? Since research in the field is scarce this might be a problem,

so the solution is for South African researchers to attempt reconciling the current regulatory

risk terminology with that of factor investing so as to garner confidence from the regulator.


Overall, it seems that rigorous factor investing is still in its infant years globally, but as it gains track

the path will be opened for more confidence in the South African context. Nonetheless, with the

world class financial markets in South Africa there seems to be very little reason for factor investing

to be impossible here.

5 Conclusion

This essay investigated the use of systematic factors in the investment process. Factor premiums

provide excess returns for investors whose portfolios are adequately suited to utilise them. The most

important style factors identified in the literature include value, momentum, liquidity, volatility, size,

term spread, credit and convexity. There are several ways to imbed factor investing into the

investment process, such as risk due diligence, factor tilts and factor optimization. Many

considerations need to be made concerning topics such as investor bad times, investability,

weighting and liquidity before a decision can be made regarding the use of factor investing.

Checklists were presented to help fund managers determine whether their fund and their country

are adequately suited to the implementation of factor investing. It was found that although South

African markets are very well suited to this approach, there is a need for more research regarding

systematic factors in the country for it to gain confidence in the general investment circles.


6 References

Ang, A. 2013. Asset Management: A Systematic Approach to Factor Investing. Oxford University

Press

Koedijk, C.G., Slager, A.M.H., Stork, P.A. 2013. Investing in Systematic Factor Premiums. Research

Report for Robeco, August 2013

Koedijk, C.G., Slager, A.M.H., Stork, P.A. 2014. Factor Investing in Practice: A Trustees’ Guide to

Implementation. Research Report for Robeco, January 2014

Norwegian Ministry of Finance (NMF) 2013. The Management of the Government Pension Fund in

2012, Meld. St. 27 (2012–2013) Report to the Storting

NORTH- WEST UNIVERSITY INVESTING IN SYSTEMATIC FACTORS BWIN 816 – Modern Portfolio Theory

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