Does Factor Investing Work in Private Markets?

Andrew Ang, Head of Factor Investing Strategies at BlackRock

Does Factor Investing Work in Private Markets?

Creating Better Diversification

Factor investing has taken the equity markets by storm, but so far it has proven difficult to adopt this approach in other asset classes. Yet Andrew Ang, Head of Factor Investing Strategies at BlackRock, believes return drivers in all asset classes can be explained by factors, even in private markets.

“Factors in private markets are the frontier,” Ang says in an interview with [i3] Insights.

Factor Investing and Correlation

“We want to understand the true drivers of returns and to do that we have to look through to factors.

“There are common components that drive private market assets as well as public market ones. We’ve seen a good illustration 10 years ago, during the financial crisis, where just putting the word private in front of equity didn’t mean that that asset class had uncorrelated returns with traditional public equity.

“When economic growth slows, public equities tend to underperform, but private equity does too. And when inflation is very high, public fixed income securities tend to underperform, but real estate underperforms as well.

“It is true that there are thousands of academic papers on value and momentum in public markets, but there are relatively few in private markets. But intuitively, we know that these exist.

“For example, real estate is all about a cap rate. A cap rate is the inverse of the yield and you obtain high yields with low prices, so real estate has some value [factor].

“We see long swings in real estate prices, so real estate exhibits momentum. But getting data on individual real estate transactions can be challenging.

“So if we don’t look through the asset classes to the true drivers of returns, we open ourselves up to unintended exposures. We can create better diversification by using factors in both listed and unlisted assets.”

Rules-based Private Equity Strategies

But the fact Ang believes all investment returns are driven by identifiable factors doesn’t mean every asset class can be systemised into a cheap and cheerful smart beta strategy.

“If you would be able to create a smart beta, publicly traded version of private equity, then there would be no point of investing in that private market asset class,” he says.

“We opt to invest in private equity to get something extra; a unique source of return.

“I think a true, value-added private equity investor would be giving you a specific return to that asset class that is not replicable by public market factors.

“In private equity, specific returns can come from control rights. It can come operationally from changing a company’s practices, from giving guidance to opening up new markets. It could come from management skill. Those are all specific sources of return from that asset class.

“Private equity has unique factors that set itself apart from other asset classes and as such it can’t be replicated by a smart beta strategy that only invests in public markets.”

Creating Better Benchmarks

But if you can’t systemise a factor approach to private markets, then what is the point of identifying factors in the first place, you might ask.

Ang explains that ultimately it comes down to creating better diversification and better risk management, but also to be able to set better benchmarks to help identify the unique skills of a manager.

“There are some components of private market returns, let’s take private equity, that are common to public markets. Public equity has large exposure to economic growth. Private equity is still a company and also has a large exposure to that macro factor,” he says.

“Private equity is often levered and also has exposure to real rates, inflation and credit. Those we can express in public fixed income. Private equity seeks to buy cheaply, so it has some style factors. Many private equity investors search for sustainable cash flow so there is an element of quality.

“To the extent that we can match those effects in public market factors, that is a benchmark and we seek to obtain returns in excess of that benchmark.”

“In every asset class there are common components [to public markets]. Those common components, if they can be expressed in smart beta or macro factors, then we should do that because it is the most cost-effective way of accessing those sources of returns.

“It enables us to hold any strategy to a higher standard, making sure that when we pay for skill we are really getting unique components of that skill.”


[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.