Roundtable 'Market Cap Weighted & Factor Investing: Making up the Balance'

August 31, 2023

Under the new pension system there will be a greater need for more stable investment products, lower volatility and fewer drawdowns. This may create more room for the factors of quality and low volatility, of course in combination with ESG. But the more efficient you want to be from an ESG standpoint, the more concentrated the portfolio.

By Hans Amesz

The trend towards sustainability and more impact seems to lead to more concentrated portfolios. What does this mean for passive and factor-driven portfolios? Can you still stick to market cap investing and is it still possible to capture factors efficiently if the number of names in a portfolio continues to be reduced?

Svetlana Borovkova: 'We take an in-depth look at strategies that use different types of ESG information to construct portfolios. It turns out that excluding names, for whatever reason, does not automatically lead to a better sustainability performance of the portfolio. I have serious doubts about even the fundamental premise of this kind of strategy.'

Antoine Lesné: 'The more efficient you want to be from an ESG point of view, the more concentrated your portfolio needs to be. The key question is how you do that to achieve your goals. It is very difficult to provide evidence of better ESG performance. Even if you had accurate data from an ESG point of view over the past ten years, the time frame is too short to say that you have performed better or worse. So you have to accept that there are deviations.'

Joop Huij: 'A direct consequence of implementing sustainability is a more concentrated portfolio. What does that mean for diversification and factor premiums? We investigated that and the results were quite surprising. In terms of the necessary diversification, there are far fewer names to invest in than we usually see. With about six hundred (instead of six or even ten thousand) names, you achieve the most you can with diversification. You can also significantly narrow the breadth of the investment universe without hurting the performance of a passive or factor strategy. I think the main dilemma is how to define 'sustainability'.'

Mark Voermans: 'Passive or factor investing is possible with fewer shares. I don't foresee a problem with a hundred or two hundred. You do need to pay close attention to portfolio construction and make sure your portfolio is well diversified. As more exclusions or other choices are made, the risk of unintentional exposures increases. That is doable with a few hundred shares.'

Marc Vijver: 'If you add sustainability factors to a universe, you are effectively already implementing factors that you might find attractive – momentum, size and so on. If you look for other factors, you will be in a more difficult position to implement them. As for market cap investing, I think that should be possible.'

Is there a correct definition of sustainability?

Huij: 'The sustainability ratings of the various rating agencies differ greatly from each other. How then can you compare which measure better indicates what is good and bad? We checked the sustainability score of the companies on the exclusion lists of large institutional investors. The results were quite shocking. About 20% to 25% of the excluded companies received an AAA rating from the major agencies, while we naturally expected a very low rating.'

Borovkova: 'According to various rating agencies, British Tobacco was at one point the company with just about the best ESG rating in the FTSE 100, even though it is on the exclusion list of many investors. Why? Because the company practices highly sustainable farming, has fantastic community outreach, and hires all diversities and women. So it scores extremely high on all parameters from different data suppliers, but no questions were asked about the products anywhere.'

If you add sustainability factors to a universe, you are effectively already implementing factors that you might find attractive.

Lesné: 'There is no agreement on how sustainability should be defined. Even regulators – think of the SFDR chaos – are grappling with which common definition would be acceptable from a political standpoint. We have to start with the regulators to try and understand what we want to do.'

Voermans: 'We prefer to implement a client's sustainability objective in portfolios. This concerns sustainability themes that the customer has chosen himself. Based on a conversation with a client, we look for ESG data points that best fit those specific themes and create exposure in the portfolio to those themes. But indeed, I would not recommend using a generic ESG rating if you are pursuing sustainability.'

Martijn Rozemuller: 'When we launched the first sustainable ETF more than ten years ago, there was still a serious debate about its definition. I had expected that debate to be over by now, but that is still not the case. Even the regulator is not able to offer a clear perspective on how we as a sector should deal with this. For me it is ultimately a kind of 'best effort'. As an industry, we should at least do our best to come to something that is justifiable, but ultimately it is the companies that in some cases clearly need to change their behavior.'

Lesné: 'We use data from various data providers, combine it with our own research and then come up with our own sustainability score.'

What does the pursuit of sustainability mean for returns?

Rozemuller: 'When we launched our first sustainable ETF, we had a similar fund, but without sustainability screening. We were able to compare the two over an eight-year period, and performance-wise they weren't really that different. One year the sustainable ETF did slightly better, the next year the other ETF. Both had about 250 components, with roughly sixty to seventy different names. The fact that performance did not differ significantly even over an eight-year period was surprising to me.'

Borovkova: 'First, I think the financial performance is different for an exclusion strategy than for a best-in-class equity strategy. These strategies differ significantly in terms of returns. The second point is that if sustainability is your mandate, you may be willing to sacrifice 1%, 2% or whatever percentage per year in returns for a more sustainable portfolio. But in many cases the mandate is solely aimed at the highest possible return, for example for the pension. I think that investors and companies should be very careful in this area and that the ongoing litigation in the United States is a warning in that regard.'

Rozemuller: 'Our first responsibility as an industry is to deliver performance. I think from a regulatory perspective we are being forced into too much of a template, which is not necessarily conducive to delivering returns.'

It is probably much easier to reduce climate risk in a fixed income portfolio than in an equity portfolio.

Is it possible to reduce the portfolio's climate risk without hurting returns?

Huij: 'I think it depends on the extent to which you want to reduce the climate risk. It would be good if we agreed on a standard. The standard that is often used for this is the Paris-aligned benchmark. We did research and it showed that it is possible to achieve exactly the same return with a passive or value strategy, while maintaining the requirements necessary for the label 'Paris-aligned'. So the answer is 'yes'. You can actually go quite far in reducing climate risk without negatively influencing the expected return.'

Lesné: 'It is probably much easier to reduce climate risk in a fixed income portfolio than in an equity portfolio.'

Rozemuller: 'You can probably assume that with a good ESG screening you end up with companies that have better risk management. Without having clear scientific evidence for this, I assume that the risk-return ratio can be improved by ESG screening.'

Borovkova: “My point is not about the climate, but about the social aspects of ESG. Many sociological studies have shown that diverse teams and companies perform better in the long run. That is one of the social aspects of the ESG story. There is potential if you are able to identify the kind of companies that will do better in the long run.”

Between 2018 and 2020, many factor-driven portfolios underperformed. Has this led to new insights, reallocations or adjustments?

Rozemuller: 'I remember that low vol turned out very differently than expected at a certain point, probably due to some kind of black swan events. As an industry, we have to keep in mind that your strategy can be messed up for all sorts of reasons you haven't considered. You can have an opinion on assets or sectors, or even individual stocks, but ultimately it's about choosing the specific strategy or sector or stock at the right time.'

Borovkova: 'We should not only look at the performance of the various factors, but also assess them in the context of the global economy. For example, investors tend to forget that the “growth” factor thrives when interest rates are low and “value” does not. Now we are entering a period of higher interest rates and then the reverse applies.'

Are factors just coincidence or do they actually contain rationality?

Rozemuller: 'I think that factors and themes can be a kind of self-fulfilling prophecy to a certain extent. If everyone jumps on the bandwagon, the valuation will rise, but at some point investors will get disappointed and leave. This means that you must diversify and not limit yourself to one factor or one theme. Make sure you stay rational and rebalance, because that's the only way to avoid getting out at the bottom and trying to get back in when it goes up again.'

You can actually go quite far in reducing climate risk without negatively affecting the expected return.

Borovkova: 'I believe Warren Buffett said that you have to take losses until they turn into profits.'

Rozemuller: 'Some people really try to hold on to their losses until they make a profit. If you do that with a single stock strategy, you're doomed to fail. It will probably work in a much more diversified portfolio.'

Huij: 'With regard to all relevant factors that exist, we have consistently established that you can actually earn factor premiums without taking on high risk. We therefore think that the hypothesis that there is a risk-based interpretation of the existence of factor premiums is not very likely. The existence of these premiums, I think, is more in the behavioral sphere. It is also interesting in this context that many investors, even seasoned investors, seem to confuse good companies with good investments. What creates the behavioral biases of investors that give rise to the existence of factor premiums? Perhaps the tendency of investors to walk away after a short period of underperformance also plays a role.'

In a pension fund, who should make the decision to invest in certain factors?

Vijver: 'That is the board, which is fed with information from advisers. You have experienced professionals here versus part-time board members, who are not seasoned investors. There is an enormously skewed relationship there, which is a major problem. Compared to about five years ago, there is a significant improvement. Professional investors such as pension funds must now have investment cases, which state, among other things, whether they want to invest passively or actively, whether they want a segregated mandate or a fund, a higher or lower tracking error, ESG standards, et cetera. With that you go from 'push' to 'pull'.'

Lesné: 'With a pension fund, just like with a central bank, an independent board is very important in order not to be influenced too much by banks and fiduciaries, for example.'

Macroeconomic changes have had a major impact on equity returns in recent years. Do you somehow factor macro factors into portfolio construction?

Huij: 'Factors tend to behave differently in the different cycles of the economy. The problem with applying that insight is first of all that you have to be able to accurately predict the business cycle, which is very difficult. And second, almost all studies done in this area overlook the trading costs associated with rebalancing. We believe in diversification and a buy-and-hold strategy.'

Voermans: 'No, we prefer a good spread over scientifically proven risk return factors to the use of macroeconomic variables. We mainly make products with a low tracking error and low turnover. Macroeconomic factors cannot be put to good use in this.'

If everyone jumps on the bandwagon, the valuation will rise, but at some point investors will get disappointed and leave. This means that you must diversify and not limit yourself to one factor or one theme.

Lesné: 'We see investors trying to time the market and entering and exiting based on that. That is extremely difficult. In terms of trading costs, it might be helpful to bet big in order to overcome those costs, so to speak.'

Rozemuller: 'I am more of an agnostic investor, which means that I do not try to predict the market and do not look too much at macroeconomic conditions. One of my favorite forms of investing is equal weight. Because the portfolio will react to macroeconomic conditions, the portfolio tells me what to buy and what to sell. This agnostic way of investing looks good in the long run, but like any other strategy, you have to be able to ride it out. A disadvantage of equal weight is the trading costs. So you have to think about the rebalancing strategy and keep the frequency of rebalancing as low as possible.'

Are there opportunities for factor investing within asset classes other than equities, for example within fixed income and commodities?

Lesné: 'There are now a few funds that invest more systematically in fixed-income securities. We have been able to show that it may be beneficial to consider certain types of companies based on their price-to-earnings ratio, their price to book or their creditworthiness.'

Rozemuller: 'We and other providers have a so-called fallen angels strategy. Can you speak of a factor in this context?'

Lesné: 'It is a form of a factor. In the world of fallen angels you have forced sellers such as pension funds, insurance companies and asset managers who have an investment grade index. So there is a direct price impact on the bond in question when it is downgraded. Another interesting element is formed by bonds with a remaining term of less than one year. When rebalancing, we sell those bonds. If there is less liquidity – that does not apply to treasuries – there is essentially some form of premium that you can reap.'

Voermans: 'In addition to factor investing in equities, we also have a rule-based product in commodities. We have identified three key factors within commodities that we systematically address: commodity selection, curve positioning and roll timing. This strategy works very well.'

Huij: 'I think there is also some evidence that factors can be identified for treasuries, high yield and real investment trust. I recently saw a study that showed that factors are even relevant to private equity deals. So factors are indeed observed in a whole range of asset classes.'

We prefer a good spread over scientifically proven risk-return factors to the use of macroeconomic variables.

Borovkova: 'And are they the same factors or different, new factors?'

Huij: 'The same factors, so value, momentum, small-cap effect and so on. We have been implementing it in credits for some time now, but also in emerging markets.'

More and more alternative data are available. Has this already found its way into factor portfolios?

Borovkova: 'We are very active in this area. I have been working with big data providers since 2009 in the field of 'sentiment', i.e. the news and social media sentiment. I think sentiments in particular, fast-moving data from freely accessible sources around the world, could be excellent signals regarding factors or risk, for example. In terms of ESG, there is now a movement not to rely on the big, slow ESG data providers, but on sustainability, climate-related information that is obtained in the same way as the sentiment data, so from open sources, using natural language processing , machine learning, and artificial intelligence. These types of information sources are much more difficult to manipulate than the information provided by companies themselves to the major data providers. If there is something about an oil spill on Twitter, for example, it will not immediately be visible in the communication of the companies involved. They will try to smooth things over. But Twitter can explode from such information, so to speak. I strongly believe in this, but understand why asset managers generally don't use this kind of information. It is expensive, requires a lot of computing power and requires a lot of expertise to use it properly. But I think it is an excellent addition to multi-factor strategies.'

Is this factor investing in a different way or is it something completely different?

Borovkova: 'If you look purely at correlations, it is very low correlated with other factors. For example, we thought that a sentiment-based factor, of social media use, would correlate with momentum, but that's not the case. It's about different information and I don't know how to untangle it. The trick is to convert this kind of alternative data into usable signals. We have helped several asset managers – not hedge funds – implement these types of signals in addition to their active strategies. Traditionally, hedge funds were the first to embrace it, but others have since successfully implemented these types of signals. It is clear that most large financial companies are testing artificial intelligence to see how it can be taken advantage of when it comes to creating strategies.'

Voermans: 'We do not use machine learning to compile our portfolios, but we do use it a lot to explain the positions in those portfolios. With this we explain from which factor or which restriction in your optimization a certain position has arisen. And also afterwards, when attributing performance. This way we can attribute the performance to decisions in the process. Not only on factors, but also on the exclusion list and other ESG integration. It helps us and our customers to understand where the performance comes from.'

Huij: 'We apply big data techniques to scanning voluminous documents such as reports and company descriptions in order to assess how companies are aligned with the SDGs. With machine learning you can significantly expand the universe of companies to be assessed by analysts, whose scope is obviously limited. More recently, we have also developed a metric that measures exposure to climate transition risk by scanning news articles. We try to determine whether there is a climate shock in the market and then we try to see which companies react positively and which negatively. Based on statistical analysis, we try to determine whether that response is systematic, i.e. which companies respond systematically positively or negatively to a climate shock, in order to ultimately identify companies that are benefiting or disadvantageous from the climate transition.'

Is it to make the portfolio more robust, to deliver alpha, or something else?

Huij: 'That depends. There are customers who have alpha targets and therefore a factor strategy. There are also customers who have a passive strategy, but who then want to build in sustainability. For example, these clients want to exclude certain companies from their investment universe. That basically means that we have to come up with an estimate, such as how a company is aligned when it comes to the climate SDGs. If a company is not followed by a fundamental analyst, we tried to apply an algorithm that in turn uses company descriptions and company reports.'

I think sentiments in particular, fast-moving data from freely accessible sources around the world, could be excellent signals regarding factors or risk, for example.

Borovkova: 'But how do you do that? Do you work with external suppliers or is everything built in-house?'

Huij: 'We have a large department that deals with sustainability research and software development, so it is more efficient to do it internally. An SDG classification has been developed that we believe is better than what is available on the market.'

Do you use ChatGPT?

Rozemuller: 'We are not actively using it now, but we have asked various departments to think about a good way to use ChatGPT. I think it's still too much in its infancy. I should have more proof that nothing can go wrong or misinformation can't be passed on or whatever. Social sentiment has previously been discussed as a factor or driver for investment decisions. It might be a way of using the wisdom of a crowd, or looking into people's minds, and seeing where they're going almost before they act. That can have predictive value. The big challenge is to convince investors that it can be useful to look into it. Maybe we can sell it to institutional investors at some point.'

Finally, is there anything that still needs to be addressed?

Borovka: 'I have a question. How do the various large institutional investors, for example sovereign wealth funds and pension funds, assess what we have all discussed?'

Vijver: 'It depends on what you want to achieve as an investor. The highest return, a better world or a combination of both? Pension funds may very well strive for the highest return for their participants, but for sovereign wealth funds that may be a better environment or a sustainable country. In the latter case, the social part takes precedence over the return part. By taking these fundamentals into account when compiling a portfolio, different portfolios are therefore created.'

Voermans: 'There will be a new pension system in the Netherlands based on contributions and individual accrual of pension assets. From what we can see at this point, there will be a greater need for more stable products, lower volatility and fewer drawdowns. This potentially creates room for the quality factor and low volatility, of course in combination with ESG.'

Lesné: 'I think regulation will be the driving force. In France, for example, most public pension funds have almost completely excluded fossil fuels. Institutional investors have different beliefs, behaviors and roles. There are multiple ways to discuss, explain, sell the use of a specific factor. You don't explain the same to a state fund in Norway as to a fund in the Middle East or Asia, for example.'