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Factor Investing in Liability-Driven and Goal-Based Investment Solutions

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Factor Investing in Liability-Driven and Goal-Based Investment Solutions ———————— An EDHEC-Risk Institute Publication Factor Investing in Liability-Driven and Goal-Based Investment Solutions March 2020 ———————— with the support of Executive Summary 5 1. Introduction 17 2. Efficient Factor Risk Premia Harvesting: Improving the Performance Benefits of the Performance-Seeking Portfolio with Factor Investing 25 3. Efficient Factor Exposure Matching: Improving the Hedging Benefits of the Liability-Hedging Portfolio with Factor Investing 57 4. Improving the Interaction Between Performance-Seeking and Liability-Hedging Portfolios with Factor Investing 91 5. Conclusion 119 References 149 About Amundi ETF, Indexing and Smart Beta 159 Portfolio weights About EDHEC-Risk Institute back to their original 161 weights, can be a EDHEC-Risk Institute source of additional Publications and Position Papers (2017-2020) performance. 167 This research has benefited from the support of Amundi in the context of the “ETF and Passive Investment Strategies” Research Chair. ›2 Printed in France, March 2020. Copyright›2 EDHEC 2020. The opinions expressed in this study are those of the authors and do not necessarily reflect those of EDHEC Business School. Abstract ———————— A new approach known as factor investing has recently emerged in investment practice, which recommends that allocation decisions be expressed in terms of risk factors, as opposed to standard asset class decompositions. While the relevance of factor investing is now widely accepted amongst sophisticated institutional investors, an ambiguity remains with respect to the exact role that risk factors are expected to play in an asset-liability management investment process. The main objective of this paper is precisely to contribute to the acceptance of factor investing by providing useful pedagogical clarification with respect to the benefits of factor investing within the liability-driven investing paradigm. To this end, we draw an important distinction between the benefits of factor investing in the performance-seeking portfolio and its benefits in the liability-hedging portfolio. We also argue that adopting a factor investing lens offers new useful insights with respect to the improvement of the interaction between performance-seeking and liability-hedging portfolios. Overall, our paper can be regarded as a first step towards the introduction of a comprehensive investment framework blending liability-driven and factor investing, widely recognized as the two most significant advances in institutional money management over the last two decades. An EDHEC-Risk Institute Publication — Factor Investing in Liability-Driven and Goal-Based Investment Solutions — March 2020 ›3 ABOUT THE AUTHORS ———————— Lionel Martellini is Professor of Finance at EDHEC Business School and Director of EDHEC-Risk Institute. He has graduate degrees in economics, statistics, and mathematics, as well as a PhD in finance from the University of California at Berkeley. Lionel is a member of the editorial board of the Journal of Portfolio Management and the Journal of Alternative Investments. An expert in quantitative asset management and derivatives valuation, his work has been widely published in academic and practitioner journals and he has co-authored textbooks on alternative investment strategies and fixed- income securities. Vincent Milhau is a research director at EDHEC-Risk Institute. He holds master's degrees in statistics and economics (ENSAE) and financial mathematics (Université Paris VII), as well as a PhD in Finance from the University of Nice-Sophia Antipolis. His research areas include static and dynamic portfolio optimisation, factor investing and goal-based investing. He has co-authored a number of articles published in several international finance journals. ›4 An EDHEC-Risk Institute Publication — Factor Investing in Liability-Driven and Goal-Based Investment Solutions — March 2020 ———————— Executive Summary ———————— Executive Summary ———————— A new approach has recently emerged in and a “minimum risk” portfolio, which, in investment practice known as factor investing, asset-liability management, is the liability- which recommends that allocation decisions be hedging portfolio. In the liability-driven investing expressed in terms of risk factors, as opposed framework, the relative allocation to these two to standard asset class decompositions. While building blocks depends on outstanding dollar the relevance of factor investing is now widely and risk budgets, and also on its periodic revision accepted amongst sophisticated institutional in reaction to changes in the opportunity set. investors, a number of questions remain with respect to the exact role that risk factors In parallel, the recent emergence of factor are expected to play in an asset-liability investing is also connected with advances in management investment process. The main financial economics, and more specifically with objective of this paper is to contribute to the academic research on asset pricing, notably widespread acceptance of factor investing including the work of Eugene F. Fama (another by providing some clarification about the Nobel Prize winning economist) and Kenneth R. benefits of factor investing within the French. Factor models have long been used for the liability-driven investing paradigm. analysis of a portfolio risk and performance, but starting with an influential article published in Modern portfolio theory provides conceptual 1993 by Fama and French,1 factors have gained a justification for the use of factor investing in new status as explanatory variables for stylized liability-driven investing strategies. It also provides facts that were previously regarded as puzzles. some guidance for the choice of factors and Fama and French proposed to interpret the size suggests that adopting a factor investing lens can and value effects in equities – broadly speaking, offer useful new insights on the proper design small stocks tend to outperform large ones and of both the performance-seeking and liability- stocks with high book-to-market ratios tend to hedging portfolios. outperform those with low ratios – in terms of factor exposures: if the market capitalization and The concept of policy portfolio has long been a the book-to-market ratio proxy for exposures to cornerstone of institutional money management, undiversifiable risk factors, then stocks with a small where it refers to a portfolio intended to strike a capitalization or a high ratio are more exposed to balance between performance and risk relative these risks, which justifies a premium. Although to a benchmark, the benchmark being the value it does not identify the underlying factors, this of liabilities for investors facing commitments. explanation fits the class of theoretical asset However, modern portfolio theory, pioneered by pricing models previously developed by Robert the work of Harry Markowitz, William F. Sharpe Merton with the Intertemporal Capital Asset and Robert C. Merton (all awarded the Nobel Prize Pricing Model (ICAPM) and by Stephen A. Ross in economics), shows that the optimal trade-off with the Arbitrage Pricing Theory (APT). Beyond between risk and return is in principle obtained by such risk-based interpretations of patterns combining a “performance-seeking” building block related to size, the book-to-market ratio or 1 - Fama, E. F. and K. R. French. 1993. Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics 33(1): 3–56. ›6 An EDHEC-Risk Institute Publication — Factor Investing in Liability-Driven and Goal-Based Investment Solutions — March 2020 Executive Summary ———————— other characteristics, there is another category has produced many (perhaps too many) candidate of economic rationales according to which these “pricing factors”, defined as factors that explain patterns reveal some form of market inefficiency differences in expected returns between assets, or incomplete rationality of market participants. but not all of them appear to be statistically and economically significant. In investment practice, In investment practice, the interest in factor the notion of factor is more polysemic, and a case investing has been driven by several forces. can be made that different applications call for First, there has been increasing recognition that different definitions. This paper illustrates the traditional cap-weighted indices have a rather flexibility of the factor investing paradigm by bad risk-return profile, which can be improved explaining how factors can be used at each stage by investing in stocks endowed with certain of the liability-driven investing (LDI) process. observable characteristics, such as low size or high book value relative to capitalization. Second, investors have become increasingly concerned In the performance-seeking over active management fees and the broad portfolio, the objective is to lack of robustness in generating positive and persistent alpha. As a result, they have started harvest risk premia. to search for added-value investment vehicles with a performance that can be justified by solid economic arguments and does not require In the performance-seeking portfolio the complex and expensive processes to select and objective is to harvest risk premia across and allocate to securities. Third, the 2008 financial within asset classes in the most efficient way crisis has led to renewed interest in sound possible, which is achieved by diversifying risk management practices, so investors are away unrewarded risk exposures. Equities increasingly inclined
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