10-07-2012 | Insight | David Blitz, PhD
“Why limit yourself to the equity premium,” asks David Blitz, Head, Robeco Quantitative Equity Research, “when there are systematic factor strategies that outperform market-cap-weighted benchmarks?” Recent research from Robeco looks at how to translate the theory of factor premium investing into practice. Innovative institutional investors are reassessing their David Blitz describes how research by academics and pensions funds is providing the basis for a transition to a new way of thinking about strategic equity allocations.
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The Norway model
One of the most influential studies was conducted for Norges Bank Investment Management (NBIM), which is the largest pension fund in the world and responsible for managing Norway’s oil wealth. The research began as a long-term evaluation of the pension fund’s active management strategies.
Three distinguished academics, Andrew Ang (Columbia Business School), William N. Goetzmann (Yale School of Management) and Stephen M. Schaefer (London Business School) produced a comprehensive report revealing that approximately 70% of all active returns to NBIM since its inception in 1998 could be explained by exposures to various systematic factors.
While evidence of a return from active management was appreciated, the analysis exposed that the source of the return was actually a byproduct of bottom-up security selection.
The authors recommended that NBIM begin using “a more top-down, intentional approach to strategic and dynamic factor exposures.” While NBIM has not yet followed this advice, strategic allocation to factor premiums was subsequently dubbed “the Norway model.”
Other large pension fund managers, however, have taken action. PGGM, for example, which manages EUR 100 billion for the Dutch health care sector, was a first-mover. It restructured its equity portfolio in this direction some time ago, allocating 40% of equity holdings to three factor premiums: value, low-volatility and quality.
More recently, PKA, a large Danish pension fund, cited the results of the NBIM study as an input into its changes in strategic equity allocation. While not yet fully implemented, it is targeting exposure to a range of equity factor premiums, such as value, momentum and low-volatility.
The rise of factor premiums
Obviously, the shift in interest toward factor premiums did not happen overnight. As Blitz explains, it began years ago when academic research began to question the efficiency of market-cap-weighted indexes. “There is a stream of literature that clearly says that market-cap-weighted indexes are not efficient and that other strategies, such as those focused on value and momentum, yield attractive returns,” says Blitz.
Ignoring these premiums has been cited as the reason so many mutual funds fail to outperform benchmarks, leading to the impression that active management is ineffective. “In fact,” notes Blitz, “research by Robeco and others has found that there are certain types of funds that do beat the market. These are the funds that are following systematic factor strategies, such as value and momentum. It is possible to beat the market-cap index using factor premiums.”
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