Asset owners who are contemplating the adoption of factor-based investment techniques into their strategy are immediately faced with a dilemma: How do I allocate to it?
Do you stick with traditional asset classes, such as equities, fixed income and alternatives and try to allocate from each bucket to certain factors, or do you create a separate tranche for your factor investments?
Factors: A Separate Asset Class
Shawn Wischmeier, Chief Investment Officer of the Minnesota-based charities collectively referred to as Margaret A. Cargill Philanthropies (MACP), is a proponent of the latter approach and describes factor strategies as a separate asset class altogether.
“How would it not be a separate asset class? If you find something that has no, low or slightly negative correlation to everything else in the portfolio, then by definition it is a separate asset class,” Wischmeier says in an interview with [i3] Insights.
We would start with very well-published and understood premia: carry, value, momentum across equities, sovereign bonds, FX rates and commodities. Those areas have been well studied by academics for decades.
His colleague, Michael Ruetz, Director of Risk Management and Asset Allocation, adds there is also a practical reason to view it this way, because it allows the fund to implement passive, rules-based strategies rather than handing out yet another mandate to a fund manager.
“We feel it is an important aspect to manage factors as a separate asset class because otherwise the only way to execute on the strategy would be to give money to some commingled structure that would be actively managed,” Ruetz says.
“To us that just means you have substituted some of your assets for more active management. But this way we are able to manage the allocation to the individual premiums, which is similar to how we manage our public market investments.”
Margaret A. Cargill
Margaret A. Cargill was an American philanthropist, who used her inheritance to support various organisations, including the American Red Cross and The Nature Conservancy.
She was the daughter of Austen Cargill and granddaughter of WW Cargill, and became one of eight heirs to the fortune of Minneapolis-based grain-trading conglomerate Cargill, the largest privately held corporation in the United States in terms of revenue.
During her life, she always made her donations anonymously, but upon her death in 2006 the charity organisations she established were collectively referred to as Margaret A. Cargill Philanthropies in her honour.
She left behind more than US$6 billion for charity when she died in 2006 and according to the public reports for each charity, MACP collectively donates about US$250 million a year through two grant-making entities.
Wischmeier and Ruetz joined the fund in 2012 and are hoping to make most of the fund’s wealth by bringing down the overall volatility of the investment portfolio while at the same time diversifying risk without giving up returns.
The fund created the new factor sleeve to the portfolio in June 2016 and started allocating based on the most well-known factors.
“We would start with very well-published and understood premia: carry, value, momentum across equities, sovereign bonds, FX rates and commodities. Those areas have been well studied by academics for decades,” Wischmeier says.
“We are just taking basic things that have been expressed in our portfolio, in different segments, different allocations, extracting those out in a purer form. Then you can work with those building blocks: you can isolate them, you can size them up, and work to perfect how they are expressed.”
Sizing Up Factors
The initial allocation to factors is relatively small at 3 per cent of the portfolio, but plans are to make this a more meaningful allocation over time if the program continues to meet its objectives. The program is still in its early stages of operation, so too early to tell if its early success will continue.
“Management gave us a 3 per cent allocation to see if we could handle it all operationally, but it is with the understanding that it will be a larger part of the portfolio,” Ruetz says.
“We have 3 per cent today and will size it up to 5 per cent soon. And perhaps in the future we may have a larger allocation.”
The team has started to put various positions in place, all passive exposures. Wischmeier says this was a logical place to start, but doesn’t rule out adding active management strategies at some point in the future.
“Currently, everything is passively implemented, but we are not against active management. Passive is just where we started. Additionally, some premia are transitory over time, so we may consider an overlay to overweight or underweight premia in different regimes,” he says.
The fund also applies leverage to the strategies to achieve its return objectives.
“If you think of long/short premium for example – say you go long value and short the growth index – then over time you expect you isolate that premium,” Wischmeier says.
“Well, it is not a very large premium unlevered, so you might only get a few per cent out of those strategies, for example. To get that to the right risk level in the portfolio we must use leverage.
“Leverage is not necessarily a dirty word; it is just another tool in the portfolio that has to be managed. So yes, we are leveraging up between five and six times right now. That level allows us to achieve an ex ante volatility target.”
The fund targets a volatility of 10 per cent, while the risk premia strategies target a slightly lower volatility due to the expectation of a higher Sharpe ratio combined with a desire to be conservative on the use of leverage.
“If this is a separate asset class in the portfolio and our goal is to hit a certain risk/return level with the rest of the portfolio, then we want it to be comparable,” Wischmeier says.
“So the rest of the portfolio has an ex ante volatility of 10 per cent and this is run a little lower at 8 per cent, but with the higher expected Sharpe ratio we expect a similar return. Additionally, the risk premia allocation has achieved a slightly negative correlation with the rest of the portfolio since inception.
“We are not trying to replicate a hedge fund; we are just trying to extract the premia.”
Shawn Wischmeier and Michael Ruetz spoke about the implementation of their factor approach at the [i3] Investment Strategy Forum held on 4-5 May 2017 in Torquay, Victoria.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.