By Kristen Mierzwa, managing director, ETP strategy & business development
My favorite question and answer session at the recent Morningstar Investment Conference in Chicago did not occur on the main stage, workshops or breakout sessions. Although I enjoyed hearing Cliff Asness share his considerable insight on multi-factor investing and was intrigued to hear industry experts and academics consider whether index funds are eating the world, I was challenged the most by the financial advisors who stopped by our booth.
The depth and breadth of the questions we received from advisors demonstrate how the industry’s overall knowledge and understanding of how to use index products has advanced. Five years ago, it was broad market cap equity indexes with perhaps some smart beta mixed in. More about one product and one asset class and less about multiple asset classes and how they work together.
Today, it’s fixed income, ESG, private equity, factors and any combination or permutation thereof. The conversation has certainly evolved as index-based or index-informed approaches have become a major part of passive and active investment strategies. Here’s a sample of the topics we discussed with advisors:
1. How can I be more sophisticated in my use of factors?
We’re able to isolate individual factors or combinations of factors. This means that we can identify specific factors while neutralizing all other factors. So for example, we can help investors create a large cap portfolio that minimizes exposure to negative factors while isolating value and momentum, for example, together.
2. In what new ways are index solutions enabling ESG investing?
We’ve actually seen a convergence of factors and ESG — earlier objectives of ESG indexing were to screen out a specific type of security that didn’t fit the investor’s values such as tobacco or guns, but the downside was that investor may have missed out on the investment benefits of a given security type. Because of new tools we’ve created, we’re now able to use factors to match the exposure to other securities. For example, if tobacco were exhibiting momentum or another factor, we can identify alternative securities to own so the investor maintains their optimal exposure while investing in line with their values.
3. Does factor investing work in the fixed income space?
Yes, but it’s much more complicated in fixed income than equities. A good example is Value. As we describe in our recent paper Fixed Income Factor Research Series: The Value Effect, there are multiple approaches to capturing the value effect in fixed income.
Depending on the proposed definition, one might look at such factor as the representation of a real risk premium or as an approach to capture relative value. In the paper, we put forward our first analysis of value in fixed income and outline an approach to the factor by utilizing a model-implied OAS framework to identify under- and over-valued securities.
In our approach, we employed a highly controlled deciling and reweighting mechanism to best preserve the credit rating, maturity and industry allocations and reduce the tracking error from unwanted sources. The simulation results across various global corporate bond markets showed that the value factor could unlock additional returns, though mostly accompanied by higher volatilities due to cyclicality.
Good advisors have and always will be curious; today they have even more to be curious about. Their questions show they are very benchmark aware and seeking information about how to build the optimal portfolio using indexes. And the advisors I spoke to at the conference aren’t constrained by index family or brand name. As a fiduciary, they will seek the best mix of puzzle pieces that complete the most optimal portfolio of market exposures for their client.
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