factor investing, esg, mdi strategies...

A Special Industry Event held by:

MONITORBenefits and Pensions

FACTOR INVESTING, ESG, MDI STRATEGIES

EXAMINED

PENSION INVESTMENT STRATEGIES

BENEFITS AND PENSIONS MONITOR MEETINGS & EVENTS

BENEFITS AND PENSIONS MONITOR | May 20181

In our work with institutional inves-tors, we find three potential situa-tions regarding factor investments,” said Vincent de Martel, factor in-vesting specialist with Invesco’s

Global Investment Solutions team. Inves-tors may have no or a balanced factor ex-posure. Investors may also have a balanced factor exposure due to deliberate tilts such as an active stance into momentum or value to deliberately create an unbalance. In large organizations, this could be the

result of different teams having different tilts. Finally, there is the case of unknown factor exposure where an investor has not yet looked at factor exposures they hold or their managers, knowingly or not, have been using but haven’t told their investors or have realized themselves that they are.

This why building a solid foundation for factor investing starts with an analysis of what is being invested in exactly, he said.

The returns of any strategies can be at-tributed to three major factors ‒ macro,

style, and alpha. A factor is a quantifiable characteristic of any security that helps determine the risk and return of that par-ticular asset. To distinguish between these factors, de Martel used a music analogy. “Macro factors are what kind of music you’re listening to ‒ classical, pop. That determines the baseline. The style factor determines the particular style. Maybe it’s pop, maybe it’s disco, reggae, or techno. The third one ‒ the alpha ‒ is the genius. Being in Canada, it could be Neil Young – who was actually born here – or pick your own favourite artist, but it’s really what’s special and makes a difference,” said de Martel.

Once these three exposures have been unbundled, they can be analyzed and in-



Pension investment strategy is playing an increasingly important role in plan manage-ment as sponsors look for ways to manage risk, increase returns, and meet their funding obligations.

The Benefits and Pensions Monitor Meeting and Events ‘Pension Investment Strategies’ session brought together a collection of experts who shared current thinking on factor in-vesting and determining ESG (environmental, social, and governance) criteria that is finan-cially material to individual assets in a portfolio.

Joining Vincent de Martel, factor investing specialist with Invesco’s Global Investment Solutions team; and Adam Hornung, Associate Director, Investment Strategy, for Russell Investments Canada, RICL Institutional Business; was Kevin Zhu, Managing Director and Head of Portfolio Construction at OPTrust; who described its shift to a member-driven investment strategy.

Factor Investing, ESG, MDI Strategies Examined

Vincent de Martel, a factor investing specialist with Invesco’s Global Invest-ment Solutions team; and Adam Hor-nung, Associate Director, Investment Strategy, for Russell Investments Canada, RICL Institutional Business; and Kevin Zhu, Managing Director and Head of Portfolio Construction at OPTrust; shared some of the cur-rent thinking on ‘Pension Investment Strategies’ at a Benefits and Pensions Monitor Meetings & Events session.

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2May 2018 | BENEFITS AND PENSIONS MONITOR



trarian approach. This is the value approach found in the earnings yield or price-to-book calculations.

With implementation, the details are important because there are some very dif-ferent methodologies for ranking stocks. When building a factor portfolio, a score is put on each security. However, manag-ers have different methodologies, so it’s important to understand how each index is constructed because the details can have a large difference in performance.

Adoption has been primarily focused on the larger institutions to begin with, but “we see it starting to trickle down and now become available to a larger number of in-vestors,” he said.

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Stakeholder pressure and regulatory shifts are just two of the reasons the in-corporation of ESG (environmental, social and governance) considerations into port-folios is growing, said Adam Hornung, As-sociate Director, Investment Strategy, for Russell Investments Canada. Both internal and external stakeholders are getting more vocal on this topic and want to explore what incorporating these factors ‒ specifi-cally carbon reduction ‒ means to the per-formance of their portfolios.

“Regulatory and political shifts are taking place throughout the globe. Coun-tries like France are instituting regulations around disclosing how climate change considerations are being incorporated into investment decision-making, so going be-yond general ESG integration” he said.

Difference Between ViewsIn terms of the relative importance of

environmental issues versus social or gov-ernance considerations, there is a differ-

ence between the views of asset owners and asset managers. One survey shows asset owners overwhelmingly believe that issues related to the environment are more than double the importance of both social and governance issues. Asset managers, on the other hand, ranked governance as the most important issue. Historically, asset manag-ers have found it easier to align themselves with governance issues in researching a company’s sustainability.

Number One TrendAccording to a survey from the PRI

(Principles for Responsible Investing), the number one trend asset owners are acting on is climate change. In terms of incor-porating climate change considerations into portfolios, however, the solution set is evolving. There are much clearer direc-tives now than several years ago. As well, a report by the Taskforce on Climate-re-lated Financial Disclosures (TCFD) made a number of recommendations with the most prominent being that climate change presents global markets with both risks and opportunities that cannot be ignored. “This is a key consideration when thinking about climate change and carbon risk and how to incorporate it in portfolios,” he said.

How ESG factors are measured is also changing. First-generation metrics used a risk-management lens such as looking at the carbon footprint of a company. Many realize that carbon reserves can be a “fairly significant financial risk,” said Hornung. However, as the TCFD pointed out, “we not only want to focus on the risk side, but also the opportunities.”

One way is to identify opportunities with companies in the industries that are most at risk ‒ such as utilities or power-

vestment decisions made on how much to invest in each.

Which factor to use depends on what the investor is looking for. “If you’re look-ing for returns in the long run, that’s going to be macro factors. The benefit is that over the last 150 years, they have been uncondi-tionally rewarded so you don’t need specific skill. Style factors are a little more appealing in that we’re moving from having just as-set classes to owning these styles which can give you an additional return uncorrelated to the market and it can last for decades. Alpha is, of course, the one that’s harder to find and to keep over time,” he said.

This makes the biggest challenge deter-mining which factors to use within these. The problem is there’s no official list.

PCA (principle component analysis) is a statistical analysis which reveals that four macro factors explain 90 per cent of the returns of any asset class. For example, corporate bonds give exposure to two fac-tors ‒ interest rates and credit. Other fac-tors include growth, real rates, and emerg-ing markets. “By and large, what you find is there are only a limited number of factors that can help you replicate the performance of any asset class,” said de Martel.

One can also use a more qualitative ap-proach ‒ moving from macro to style fac-tors ‒ since human biases are one of the main reasons for the existence of style fac-tor premiums. Researchers have discovered about 200 biases investors tend to favour although there is a smaller number of ma-jor categories. These biases create price dislocations investors can benefit from as prices revert back to fundamentals.

One worth focusing on is momentum. Momentum is the tendency to extrapolate price movements. “By the way, some manag-ers don’t believe in momentum, so if you look at the Norway pension fund as an example, they decided that they didn’t want to invest in momentum because they believed there’s no premium there. The reality is that it has actu-ally delivered good results over time,” he said.

ValueAnother is value. The tendency of inves-

tors is to focus too much on the glamorous stocks which tends to make them over-priced in the long run. Identifying assets that really can be determined to have good value through time requires a more con-

BENEFITS AND PENSIONS MONITOR | May 20183



BENEFITS AND PENSIONS MONITOR WOULD LIKE TO THANK

THE SPONSORS OF THIS EVENT

ing Director and Head of Portfolio Con-struction.

With net assets of over $20 billion, OP-Trust invests and manages one of Canada’s largest pension funds and administers the OPSEU Pension Plan, a defined benefit plan with over 92,000 members and re-tirees. Using a diversified global portfolio with balanced risk factor exposures, the plan is fully-funded on a going-concern basis and its investment performance has been robust and consistent with a nine per cent annualized rate of return on average since its inception in 1995.

Maturity Challenge However, Zhu noted that OPTrust is a

maturing plan. The active-to-retiree ratio as of December 31, 2017 was 1.2 to 1, and this ratio is expected to decline further to less than one in the next five years. “This is going to be a big challenge because we are going to face a net cash outflow in an in-creasing fashion going forward,” said Zhu.

“As a true pension manager, our man-date is to ensure pension certainty to our members. As such, we measure our suc-cess fully based on the funded status of the plan,” said Zhu. “Our investment objective is to maintain our fully funded status by taking the lowest risk possible.”

He noted that many pension funds have struggled with properly aligning their goals and their operations, incentivizing invest-ment teams to focus on generating extra returns to outperform the benchmark.

“Total portfolio return and risk are what really matter in the end,” said Zhu. “Under the MDI strategy, OPTrust has transformed to become a pension manage-ment organization by fully aligning our investment strategy with our mandate to keep our promise to our pensioners.”

“We look at investments on a risk-adjusted basis. For each investment we make, we want to make sure that the risk is aligned with our goals.”

Zhu explained that OPTrust’s total portfolio management framework has two principal pillars: using a total fund-orient-ed mindset and approach in portfolio con-struction and dynamically managing risk factors through a total portfolio overlay structure.

Its portfolio construction uses a risk factor-based framework and takes into

consideration real world constraints such as risk, capital, and liquidity, and it then weighs the different trade-offs to strike the right balance in the portfolio. “We don’t operate in an ideal world and our portfo-lio construction exercise is challenging, like solving a puzzle with many different con-straints,” said Zhu.

In its portfolio construction process, OPTrust separates the liquid and illiquid portions of its portfolio to account for different investment time horizons and liquidity profiles. Once illiquid exposures are known, the portfolio construction focus shifts to the ‘completion portfolio’ where desired total fund risk and risk factor ex-posures can be managed more dynamically and effectively.

Risk/Reward Profile A total portfolio overlay structure is

created internally with the mandate to more dynamically manage the major risk factor exposures of the fund. The overlay committee constantly monitors and as-sesses external macro opportunities and risks and, within its allocated risk budget, the committee makes decisions to adjust major risk factor exposures with the goal to improve the risk/reward profile of the plan’s funded status.

“Our experience and performance over the past two years prove that our strategy is working, and we have deliv-ered what we promised to our members,” said Zhu. “We have reduced our funding risk profile, while succeeding in our ulti-mate goal of improving the funded status of the plan.” BPM

generation ‒ and identifying those compa-nies in these sectors that are most progres-sive and investing in renewable sources of energy, he said.

Marrying the underlying metrics of carbon footprint and carbon reserves with a metric of renewable energy creates a broader lens that accounts for both the risk and the opportunities and gives a better understanding on how companies are in-corporating ESG into their initiatives.

In the past, investment managers used a third-party provider for ESG scoring. Scores for individual institutions were based on 150 different considerations. However, these scores were very much centred around the median. Aggregating the scores made it “hard to really find meaning behind differ-ent companies in different sectors,” he said.

Financial MaterialityLooking for a better method, Russell In-

vestments conducted research into how to identify those ESG factors that are finan-cially material to a company and its profit-ability. Recognizing that not all consider-ations are relevant from industry to industry, company to company, the firm created a materiality map for different sectors and in-dustries. “We then weighted it based on the materiality of those issues to those sectors and effectively created a new custom ESG score for every single one of the companies in the global universe,” he said.

The results of the research and analy-sis are promising. Companies that tended to score high on material factors outper-formed companies that scored high on im-material factors. So, understanding which ESG factors are financially material to an organization may help drive performance.

Although there is a “strong link between performance and financial materiality of these ESG factors, our data set is still a little narrow. It’s only a market cycle. We think there’s a lot of evidence there that we are on the right track. We will continue to foster evolution in how we, as an industry, measure and report on the impact ESG factors have on investment portfolios,” said Hornung.

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The top priority at OPTrust is “ensur-ing we can deliver our pension promises in the long run,” said Kevin Zhu, its Manag-

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