the diversification benefits of multi-asset style factors · factors explain the absolute ......

September 2017

The diversification benefits of

Multi-Asset Style Factors

Authored by:

Benoit Bellone, Head of Equity & Multi-Asset Research, HSBC Global Asset Management (France)

Non-contractual document. This publication is intended for Professional Clients only. Retail Clients should not rely upon its content and may want to consider seeking professional advice before purchase. The information contained in this publication is not intended as investment advice or recommendation.

Non contractual document2

Investors’ dilemma:

diversification vs

attractive returns

While interest rates are at historical lows,

the bulk of future asset returns is expected

today to come from equity and “equity-like”

exposures (High Yield bonds, Emerging

Market Debt…). In a world of low nominal

growth, “growth” assets have been valued

at a high premium. Therefore, high

expected returns assets are likely to be

the exception, and some with unseen

latent risks. In such a context, building

diversified strategic portfolios with

attractive expected returns is incredibly

challenging.

The diversification benefits of Multi-Asset Style Factors

The commentary and analysis presented in this document

reflect the opinion of HSBC Global Asset Management on

the markets, according to the information available to

date. They do not constitute any kind of commitment from

HSBC Global Asset Management.

Any forecast, projection or target where provided is

indicative only and is not guaranteed in any way. HSBC

Global Asset Management (France) accepts no liability for

any failure to meet such forecast, projection or target.

Contents

Investors’ dilemma: diversification vs attractive returns 2

The revolution of Multi-Asset Factor Investing 3

What are Multi-Asset Style Factors? 4

Diversified and diversifying 6

Conclusion 10


The revolution of Multi-Asset Factor Investing

To respond to investors’ demands for higher performance, new concepts have ebbed and flowed over the years, each decade portending a new wave of innovations or, sometimes… just investment fads. Yet, we believe that the revolution of Multi-Asset Factor Investing is on its way and here to stay. This research note argues that the emergence of Multi-Asset Style Factor solutions should thus offer significant benefits to UCITS investors looking for enhancing their risk-adjusted performance and diversifying their multi-asset portfolios. But what are those factors? How is that possible?

To introduce the concept of factors, we like to refer to the analogy made by Professor Andrew Ang, who said that “Assets are bundles of different types of factors just as foods contain different combinations of nutrients”. When it comes to portfolio construction, asset allocation does not really matter (whether you invest in US or Asian equities or Emerging Debt),

what really matters is how much exposure you have to a limited number of common sources of risk: the so-called multi-asset factors.

Our research exhibits two types of factors:

• First, and they are probably the most well-known, Macro factors explain the absolute returns of the asset classes meaning the performance of equities as an asset class, of bonds, etc… Macro factors are fundamental sources of risk which are related to the global economic environment, are perceived as “directional” and are often qualified as “beta”. Growth, which portends the risk of an economic slowdown, is a macro factor that explains the returns of equities, credit, etc… Real rates and inflation are other macro factors that tend to explain the returns of bonds and commodities for instance. In terms of implementation, macro factors can be invested by taking long

exposures to the traditional asset classes and explain most of the time more than 80% of the risk of an internationally diversified multi-asset portfolio.

• Style factors cover the second type of factors. Unlike macro factors, they explain the assets’ relative returns, in excess of the return of the asset class. Style factors won’t explain the returns of equities for instance, but they’ll explain why US equities outperformed UK equities, why Australian bonds underperformed German bonds, etc… Since Style factors explain relative returns (i.e.. are non-directional), they must be implemented by taking long and short positions.

We believe that the revolution

of Multi-Asset Factor Investing

is on its way and here to stay.


The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the

information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management.


What are Multi-Asset Style Factors?

Style factors are not completely new. They have been known in the equity space since the 90’s when academic research proved that individual stocks returns could be explained not only by the performance of the equity market, but also by other characteristics such as whether the stock is more expensive or cheaper (the so-called value factor) or whether the stock is a large cap or a small cap (the size factor). Since then, research in style factors has been extended to other asset classes such as bonds, currencies or commodities. Interestingly, some factors can be implemented across all asset classes, offering stronger diversification properties.

Our research has gone through a stringent selection process to retain only three Style Factors that could be investable in a UCITS framework. To be selected, each factor had to pass four filters. It must be:

1. justified and widely documented by academic research. In particular it should compensate an intuitive and specific risk, which has its own cycle;

2. persistent across equity, bond and FX markets over time based on very long data series and robust at multiple levels (security, sector and market levels);

3. weakly correlated to traditional asset classes and other styles;

4. investable using only liquid instruments, mainly derivatives such as futures, Forex forwards, or interest rates swaps and compliant to UCITS rules.

Our research led us to reject any style that could not be qualified as a pure factor according to our criteria. This was the case for instance of specific equity styles such as the “Defensive/Low-Beta” and “Size”, or factors that are highly related to directional market risks (Volatility, Credit risk) and/or cannot be investable using liquid instruments (Illiquidity factor).

With these core principles we selected three Multi-Asset styles that we believe are the most compelling and robust, and likely to persist across time:

• The Value Style: buying (selling) assets that are cheaper (more expensive) based on traditional metrics, exposes investors to the risk of persistent deviations from fundamental pricing : market fads, bubbles or a distressed environment delaying true price discovery;

• The Momentum Style: buying (selling) assets that have out (under) performed over given horizons, is often viewed as the mirror of value-based sources of risks, hinging on persistent biases (delayed reaction to fundamental information and myopic behaviors);

• The Carry Style: buying (selling) higher (lower)-yielding assets, provides a steady source of small gains but exposing investors to potential unexpected changes in fundamentals (abrupt variations in real interest rates expectations in the Foreign exchange (Fx) complex or unexpected cuts in profits and dividends in the equity markets).





Each style shows a time-varying defensive vs cyclical bias across time and assets. For instance, Equity Carry and Momentum, Fx Value or Bond Value may provide a rather defensive bias in a

disinflation environment. In contrast, Equity Value and Fx Carry tend to outperform in the “recovery phase” of the business cycle. As illustrated in Figure 1, each aggregated cross-asset

style has followed its own cycle of expansion and contraction, while exhibiting no easily predictable or recurring pattern.


Sources: HSBC Global Asset Management, Bloomberg, DataStream. Data as at 30/06/2017.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

1.8

0.8 2.0

0.6 1.6 3.2 1.9 2.5 2.6 1.6 2.4

0.5 1.6 2.6 2.7 1.9 1.6 1.7 1.7 2.4 2.0 1.1 1.2 1.0

0.5 1.1 1.5 2.4 1.1 1.1 1.0 1.5 0.8 2.2 1.0 1.1 1.0 1.4 0.5 0.9

0.3 1.1 0.9 2.1 1.0 1.0 0.5 1.4 0.7 1.2 0.9 1.0 1.0 1.3 0.2 0.9 1.8

0.3 0.7 0.6 1.4 0.9 1.0 0.4 0.9 0.6 0.8 0.7 0.5 0.4 0.9 0.1 1.3 0.6 1.6

0.1 0.6 0.4 0.4 0.5 0.6 0.3 0.8 0.5 0.6 0.4 0.4 0.3 0.6 0.1 0.5 0.4 0.3

0.1 0.5 0.2 0.1 0.5 0.3 0.3 0.5 0.4 0.5 0.1 0.2 0.2 0.3 0.1 0.2 0.2 0.1

-0.3 -0.2 -0.3 -0.5 -0.4 0.0 -0.3 -0.3 -0.2 -0.3 0.0 -0.2 0.0 -0.4 -0.4 -0.1 -0.1

-0.4 -0.5 -0.4 -1.5 -0.1 -0.8 -0.7 -0.3 -0.3 -0.1 -0.4 -0.2 -1.0 -0.7 -0.7 -0.1

-0.5 -0.1 -1.7 -0.7 -0.8 -0.9 -0.5 -0.4 -0.8 -0.6

-1.2 -0.5 -1.0 -0.8 -0.7

-1.2 -1.2

-1.5

Equity Momentum

Bond Momentum

FX Momentum

Equity Carry

Bond Carry

FX Carry

Equity Value

Bond Value

FX Value

Figure 1: 12-month Sharpe Ratios of Aggregated Multi-Asset Style Factors





There is only one “free-lunch” in portfolio management: this is diversification. By combining weakly correlated assets with the same expected return and volatility in a portfolio, investors can either enhance their portfolio’s return, reduce its volatility, or improve both.

Within a particular asset class, style portfolios exhibit indeed low cross-correlation. This was expected since, for instance, value and momentum portfolios tend to complement each other: value portfolios tend to buy falling assets while momentum portfolios tend to buy the rising ones. Carry may exhibit a more cyclical correlation to both Value and Momentum. What was less expected, however, is that for a given style, correlations across asset classes are also low (Figure 2). This means that the value premium does not have the same meaning when implemented in, say, the equity space or in the bond space.

Figure 2: Historical Cross-Correlation of Multi-Asset Style Factors

The figures refer to simulated past performance. Simulated past performance are not a reliable indicator of future performance. Sources: HSBC Global Asset Management,

Bloomberg, DataStream. Weekly performances from 22/03/1999 to 30/06/2017.

Diversified and diversifying

1.0

Equity

Momentum0.1 1 -0.4 0.0

Equity

Carry1 0.1 0.1 0.0

0.2 0.0 0.0 0.2 -0.1

0.0 -0.1 0.0 0.10.0

-0.1

0.0 0.0 0.0 1

Equity

Value0.1 -0.4 1 0.0

Bond

Carry0.1 -0.2 0.1 0.1 -0.1

0.1 0.1 -0.1 0.1 0.5

-0.2 0.0 0.2 -0.1 - 1

Bond

Value0.0 0.0 0.1 -0.2

Bond

Momentum0.0 0.2 -0.1 0.1

- 0.5

0.0 0.2 -0.1 0.1

-0.1

- 1.0

Eq

uit

y

Carr

y

Eq

uit

y

Mo

men

tum

Eq

uit

y

Valu

e

Bo

nd

Carr

y

Bo

nd

Mo

men

tum

Bo

nd

Valu

e

FX

Carr

y

FX

Mo

men

tum

0.1 -0.1 0.1 -0.1 -0.1 0.1 -0.3 -0.4 1FX

Value

0.0 1 0.2 -0.3

-0.2 1 0.0 0.0 0.1

FX

Momentum

FX

Carry0.0 0.1 0.1 0.0

0.2 0.0 0.2 1 -0.4

FX

Valu

e




-0,2

-0,1

0,0

0,1

0,2

0,3

0,4

0,5

Style portfolios average pairwise 1Y correlation

Asset classes average pairwise 1Y correlation

Besides while macro factors and traditional assets tend to re-correlate at the worst moments (mainly periods of market stresses and economic crises), style factors tend to show very stable cross-correlation across-time (Figure 3). Besides, our research shows that during periods of market stress, contrary to macro factors as growth, inflation and rates risks which have tended to be massively aligned, the correlations between style factors have tended to shrink.

Figure 3: Asset vs Style Portfolio time varying pairwise correlations

Lehman Brothers

bankruptcy

Euro sovereign

debt crisis Liquidity

crisis


Bloomberg, DataStream. Weekly performances from 22/03/1999 to 30/06/2017.






Astute investors may thus imagine the significant potential power of diversification of a multi-asset style factor portfolio. Our research and investment experience shows indeed that a style factor strategy balancing style through a simple equal risk contribution portfolio construction is weakly correlated to the traditional asset classes (Figure 4), which confirms that they are no traditional beta. Style factors are also weakly correlated to hedge-fund indices, which means that they are no traditional alpha either. Style factors stand in-between, and are usually referred to as alternative beta.

.

Figure 4: Asset vs Multi-Asset Style Factors portfolio (MASF)

historical correlation


Bloomberg. Weekly performances from 22/03/1999 to 30/06/2017. MASF strategy simulated

performance from 22/03/1999 to 28/04/2015 and actual performance posted by a real fund thereafter,

net of transaction costs and gross of management fees.

MA

SF

Glo

balE

quitie

s

Glo

balG

ovie

s

HedgeF

undofF

und

MASF 1 0.0 0.2 0.1

GlobalEquities 0.0 1 -0.3 0.7

GlobalGovies 0.2 -0.3 1 -0.2

HedgeFundofFund 0.1 0.7 -0.2 1

1

0

-1




A style factor portfolio may thus be added to an existing traditional asset allocation and should improve its risk-return characteristics. For instance, if we consider an internationally balanced diversified portfolio over the past 18 years (30% Global

Equity, 5% Emerging Local Debt, 5% Global High Yield, 60% Global Aggregate) adding 25% of a risk balanced style portfolio targeting an annualised volatility of 7% would have boosted the annualised return by 1.5%, reduced the annualised volatility

by 1.7%, increased the Sharpe ratio and cut the maximum drawdown by half (Figure 5.).


The figures refer to simulated performance. Simulated performance are not a reliable indicator of future performance. Source:

HSBC Global Asset Management. Daily data from 22/03/1999 to 30/06/2017. MASF strategy simulated performance from 22/03/1999 to 28/04/2015 and

actual performance posted by a real fund thereafter, net of transaction costs and gross of management fees. Portfolio.1.0 and Portfolio.2.0 simulations

correspond to systematic quarterly static weights rebalancing gross of transaction costs and gross of management fees. Returns are daily and expressed in

EUR. For illustrative purposes only.

Figure 5: Diversification Gains to add a Multi-Asset Style Factor Strategy in a Balanced Portfolio

Simulated return/risk profile

Portfolio 1.0 Portfolio 2.0

Portfolio 1.0 Portfolio 2.0

Return (ann.) 4.7% 6.2%

Volatility (ann.) 8.2% 6.5%

Sharpe ratio 0.33 0.65

Max. drawdown -22% -11%

60%

5%

5%

30%

Global Aggregate Bond EMD ( Local currency)

Global HY Developed Equity

75%

25%

Portfolio.1.0 MASF

Timing or tilting style factor allocations with traditional approaches (valuation, mean-reversion and trends) may be tempting for investors. Yet, our research suggests that it remains

highly difficult as a more concentrated style portfolio has to overcome the loss of diversification benefits and supplementary transaction costs due to a higher turnover.

10

The diversification benefits of Multi-Asset Style Factors September 2017

Conclusion

Most of the performance of a Multi-Asset Style Factor strategy should come from diversification and harvesting long term risk premia which are not correlated with traditional “beta”.

UCITS investors looking to mitigate a low return, high correlation and riskier environment, providing they should be ready to use leverage, shorts and derivatives, may exploit the diversification benefits of balancing Multi-Asset Styles.

Non contractual document



The Author

Benoit Bellone is Head of Equity

& Multi-Asset Research, HSBC

Global Asset Management

(France) in the Paris office and

has been working in the industry

since 2001. Prior to joining HSBC

in 2007, Benoit worked as an

economist at the OECD in

France. He holds a Masters

degree in Economics and

Statistics from ENSAE (France),

a Masters degree in Mathematics

(DEA) from the Université Paris

IX - Dauphine and a BA in

Economics from the Ecole

Normale Supérieure Paris-

Saclay.

Benoit Bellone

Head of Equity & Multi-Asset

Research

HSBC Global Asset Management

(France)


Asset class reference indices


Source: HSBC Global Asset Management (France) – For illustrative purposes only.

Asset class Index Source

Global Equities MSCI World TR Net Bloomberg

Global Govies JPM GBI Broad Bloomberg

Hedge Funds HFRX Global Hedge Fund Bloomberg

Global Aggregate Bond Barclays Global Aggregate Bond Index Bloomberg

Emerging Debt Local Crcy JPM GBI-EM Global Div & JPM EMBI Global before 01/2002 Bloomberg

Global High Yield Bond BofA Merill Lynch Glb HY Index Bloomberg

Developed Equity MSCI Developed Equity Bloomberg

Portfolio simulation methodology

Style portfolios – portfolio construction

• Data from 22/03/1999 to 28/04/2015

• Individual style portfolios are built using long and short positions (weights add up to 0*). Weights depend on the ranking of the investment universe on the considered metric (weights are a simple linear function of the ranking).

• Style portfolios are first combined by style and then by asset using a risk-parity approach. The 3 multi-asset style portfolios (carry, momentum & value) are then combined using a risk parity approach.

• The portfolio is rebalanced on a weekly basis and targets a volatility of 7%, on average.

• The simulated performance is net of estimated transaction costs as listed below. Estimated transaction costs are tripled during “periods of market stress”**, as listed below.

AssetTransaction cost

(in basis point)

Index future 1

Bond future 0.5

Interest Rate Swap 10

Developed FX 0.5

Emerging FX excl. CLP, COP, IDR 2.5

CLP, COP, IDR 5

Equity sector future 1.5

Starts Ends

30/08/2011 31/10/2001

30/08/2008 31/01/2009

30/04/2010 30/06/2010

31/07/2011 30/11/2011

31/07/2015 30/08/2015

Periods of market stress

* Except for Time-Series Momentum portfolios which are long all the markets with a positive return and short all the markets with a negative return

** The definition of “periods of market stress” is subjective by nature and should be considered as an illustration only.



Equities

• Instruments: Index futures

• Developed country investment universe: ASX (Australia), TSX (Canada), CAC (France), DAX (Germany), MIB (Italy), TPX (Japan), IBEX (Spain), OMX (Sweden), SMI (Switzerland), FTSE (United Kingdom), S&P500 (United States)

• Emerging country investment universe: BOVESPA (Brazil), RDX (Russia), HSCEI (China H), KOSPI2 (Korea), NIFTY (India), KLCI (Malaysia), MSCI TAIWAN, SET (Thailand), WIG (Poland), BOLSA (Mexico), BIST (Turkey), TOP (South-Africa), MSCI INDONESIA (Indonesia)

• Country investment universe: ASX (Australia), TSX (Canada), CAC (France), DAX (Germany), MIB (Italy), TPX (Japan), IBEX (Spain), OMX (Sweden), SMI (Switzerland), FTSE (United Kingdom), S&P500 (United States)

• US Sector investment universe: S&P Select Sector futures (Consumer Discretionary, Consumer Staples, Energy, Financial, Industry, Materials, Technology, Utilities, Health Care)

• Europe Sector investment universe: Eurex Stoxx 600 futures (Auto, Banks, Basic Resources, Chemicals, Construction, Financial Services, Food & Beverage, HealthCare, Industrial, Insurance, Media, Oil & Gas, Household Goods, Retail, Information Technology, Telecom, Travel & Leisure, Utilities)

• Long-term Value: Adjusted P/E excluding stocks with negative P/E. Long (short) positions in the less (more) expensive markets

• Short-term Value: 1-mth performance. Long (short) positions in the worst (best) performing markets

• Cross-Section Momentum: 1yr – 1 mth performance. Long (short) positions in the best (worst) performing markets

• Time-Series Momentum: 3, 6, 9 & 12 mth performance. Long (short) positions in the markets with positive (negative) return

• Carry: Return-on-Equity. Long (short) positions in markets with the highest (lowest) Return-on-Equity

Bonds

• Instruments: 10 yr bond futures and interest-rate swaps

• Investment universe: Australia, Canada, Switzerland, Eurozone, United Kingdom, Japan, Norway, New Zealand, Sweden, United States

• Long-term Value: 10Y real rate = 10Y nominal rate – 1 yrforecasted inflation (consensus forecast). Long (short) positions in markets with the highest (lowest) real rates




• Carry: 10 yr – 3 mth slope. Long (short) positions in markets with the highest (lowest) slope

Currencies

• Instruments: FX fowards & NDFs

• G10 investment universe: AUD, CAD, CHF, EUR, GBP, JPY, NOK, NZD, SEK, USD

• EM investment universe: BRL, CLP, HUF, INR, IDR, KRW, MXN, PLN, RUB, SGD, TWD, ZAR

• Long-term Value: PPP adjusted for Balasa-Samuelson effect. Long (short) positions in the most under(over) valued currencies




• Carry: 3 mth forward implied yield. Long (short) positions in currencies with the highest (lowest) implied yield





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