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Factor Investing, Smart Beta Thrive as Investors Seek Higher Returns: SSGA

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Many investors are starting to rethink traditional investment models and consider new ways to structure their portfolios to achieve their investment goals – for instance, factor investing.

While research has shown factors such as size, valuation and momentum deliver a durable premium over the long term versus a market-cap weighted benchmark, a new research report by State Street Global Advisors finds that factor investing is attracting new interest.

“Building portfolios around factor risk exposures rather than asset classes alone is a significant shift away from traditional mindsets and governance models,” the report states. “That kind of change takes time and education, but the challenges posed by today’s markets are prompting more investors to consider a fresh approach.”

According to a recent survey of more than 400 global institutions, SSGA finds that one in four respondents felt their overall portfolio return expectations were not currently being met. And nearly all of the respondents (98%) expect significant change in the industry’s investment approach over the next five years.

Many respondents have already changed their asset allocation to address underperformance. According to the survey, 38% of investors have increased their allocation to smart beta, which SSGA defines as “part of a broad spectrum of factor-based approaches that include highly sophisticated active strategies and techniques.”

SSGA also finds that three-quarters of the respondents who had implemented smart beta said they found moderate to significant improvement in their ability to meet their long-term objectives.

Lori Heinel, chief portfolio strategist at SSGA, sees the broader uptake in factor investing as a response to lower-for-longer return expectations.

“One obvious catalyst is the expectation that returns are going to be lower than most investors had anticipated,” Heinel says in the report. “Our projected returns across all asset classes are in the low single digits, so it is clear that for the next few years just relying on beta returns isn’t going to be enough.”

The SSGA survey found generally elevated long-term return expectations across most asset classes, which according to SSGA suggests expectations have adjusted to a potential lower-for-longer return scenario. According to the survey, the mean long-term return expectations across every major asset class save commodities and bonds were in the double digits.

The survey finds investors’ 5-year return expectations were 5.5% for bonds, 10% for equities and 10.9% for portfolio.

Fabio Cecutto, senior investment consultant at Willis Towers Watson, thinks there have been important changes on both the supply and the demand sides that explain the current interest in factor investing.

“On the supply side, we have definitely seen improvements in technology and implementation capabilities, which allow for doing things in more cost-efficient and less complex ways,” Cecutto says in the report. “On the demand side, we have seen a greater focus from asset owners on their governance budget: what additional complexity they are onboarding and what true value-add they get for the fees paid. This is a trend that has accelerated since the financial crisis and has become more acute in the current market environment, where improving portfolio efficiency is much needed but traditional asset class yields are so low.” The SSGA survey also reveals what barriers are stopping investors from adopting new investment models like factor investing.

Investors haven’t yet committed to factor based investing for several reasons – 62% said lack of peer adoptions; 46% said lack of in-house expertise; 46% said lack of board buy-in; 45% said difficult to benchmark; and 39% said it was difficult to explain the concept to investors.

Based on conversations with institutional investors around the world, Nils Ladefoged, senior portfolio manager of Denmark’s PKA pension fund, has found that governance challenges and peer risk are the two biggest headwinds facing factor investing. PKA has been one of the most innovative adopters of factor investing.

 “The governance challenge is about educating your board,” Ladefoged says in the report. “You do need a good risk framework for this to work well, but that is a technicality more easily solved than the governance issues. Peer group risk keeps many institutions from allocating a larger share of their risk budgets to factor investing.”

Heinel thinks another headwind toward faster adoption of factor investing is a “lingering hesitation about quantitative investment approaches.”

“Factor investing has traditionally been the domain of quant investors and now that we’re bringing it to a broader group of investors, I think it can still feel somewhat intimidating to investors used to and comfortable with fundamental processes, even when those are less systematic and more dependent on individual judgment,” she says in the report. “But I think that is changing as we see a broad-based shift across the entire culture from fundamental approaches to more technology-informed processes in everything from investing to how you choose a restaurant or movie in much more technology-savvy ways.”

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