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In this article, the author discusses current structural research and investment trends that are shaping the future of factor investing. Specifically, the author focuses on three emerging trends: the ongoing evolution of traditional factor models and strategies, recent innovation in data sources and modeling techniques, and the potential disruption from integrating factor strategies into the asset allocation process. Key Findings ▪ Factor models and strategies evolve gradually over time, reflecting the evolution of capital markets and advances in academic theory, data availability, empirical research, and investment practice. ▪ Current innovation efforts in factor investing focus on exploiting new unstructured data sources, applying new data science modeling techniques, and integrating sustainability and climate factors. ▪ Innovation in factor investing is reshaping the traditional asset allocation paradigm by creating new opportunities for investors to express active investment views through a factor allocation process.

Factors are the underlying forces that drive portfolio risk and performance over different investment horizons. In this article, first the author reviews the theoretical foundations and practical applications of factor models. The author then discusses the integration of factors into different types of investment strategies. He concludes with a discussion of how factor models and strategies enable investors to manage total portfolio risk and capture risk premiums through the asset allocation process. TOPICS:Factor-based models, portfolio construction, risk management, performance measurement Key Findings ▪ Factor models empower investors to understand and manage the sources of portfolio risk. ▪ Factor strategies reflect factors, offering investors the ability to capture factor premiums. ▪ In factor allocation, factors replace asset classes as the drivers of asset allocation decisions.

In this article, the authors review factor performance in global equity markets using coherent data and methodology and apply a new template to evaluate their backtests for potential selection bias under multiple testing. They then propose a systematic process for integrating factor information into different investment strategies. The authors show that this process is consistent with the Black–Litterman framework and test it on a sample of market indexes and active equity portfolios. Integrating factors in indexes improved risk-adjusted performance while retaining high liquidity and capacity. Adding factors to active strategies enhanced information ratios while maintaining the portfolio characteristics and stock selection alpha of the original strategies. The authors’ analysis may have important implications for different types of investors. Asset owners may be able to tilt reference indexes toward rewarded factors without sacrificing market coverage and diversification. Index managers can track factor-tilted indexes because they remain investable and replicable. Finally, active managers may be able to incorporate factor information into their strategies to harvest factor premiums while preserving their core investment process and the added value from fundamental security selection. TOPICS:Factor-based models, portfolio management/multi-asset allocation, style investing

Many studies have focused on the relationship between companies with strong environmental, social, and governance (ESG) characteristics and corporate financial performance. However, these have often struggled to show that positive correlations—when produced—can in fact explain the behavior. The authors of this article provide a link between ESG information and the valuation and performance of companies, by examining three transmission channels within a standard discounted cash flow model—which they call the cash-flow channel, the idiosyncratic risk channel, and the valuation channel. They tested each of these transmission channels using Morgan Stanley Capital International ESG Ratings data and financial variables. This showed that companies’ ESG information was transmitted to their valuation and performance, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk). The research suggests that changes in a company’s ESG characteristics may be a useful financial indicator. ESG ratings may also be suitable for integration into policy benchmarks and financial analyses. TOPICS: ESG investing, security analysis and valuation, risk management

There has been a wide range of research in academia and the asset management industry about the financial benefits of ESG investing. However, the question of how to achieve consistency when integrating ESG has not obtained the same level of attention. As a result, ESG integration currently is often applied inconsistently and incompletely across asset owners’ portfolios. The authors of this article focus on how asset owners can implement ESG integration through index-based allocations to portfolios that seek to replicate ESG indexes. Index-based approaches offer consistency, transparency, and replicability and are generally cost-effective. Over a seven-year study period, global and regional versions of the MSCI ESG Leaders Indexes (as proxies for regional allocations) resulted in significant variations in their respective ESG profiles and performance, but in all instances, there was a clear reduction in all key risk measures.

The authors examine how a factor allocation can be integrated into an asset owner’s existing roster of active managers. Using a risk-budgeting framework, they have several findings. (1) Asset owners who wish to maintain their existing roster of active managers and incorporate factor views may consider a top-down factor implementation, funded entirely from the core passive allocation. This approach distributed most of the active risk to active managers. (2) Asset owners who wish to preserve their existing roster of active managers and incorporate high-conviction factor views may consider an allocation between active management and a bottom-up factor implementation. This approach more evenly distributed the risk budget to active management and factors and partially funded the factor allocation from active management. (3) Asset owners who pursue a barbell strategy between core passive allocations and concentrated active managers could implement a low-volatility factor allocation, which may lower the total risk of the equity program, releasing active risk budget that can be deployed to active managers.

Minimum volatility strategies enjoy broad support in the academic literature and have been applied extensively by institutional investors to reduce portfolio volatility. In this article, the authors discuss how such strategies can adapt to address risks beyond price volatility. Specifically, concentration, sustainability, and crowding risks could be mitigated using appropriate but simple optimization constraints. However, adding a diversification constraint increased exposure to residual volatility and had a negative impact on risk reduction and risk-adjusted performance. In contrast, to help manage environmental, social, and governance (ESG) risks, adding a significant sustainability constraint had only a small effect on the risk reduction properties. Finally, introducing constraints on the value exposure ensured the market-relative valuations of the strategy remained attractive for only a small increase in realized volatility. The authors show that simple constraints could be used effectively in minimum volatility strategies to manage risks beyond volatility.

1. Dimitris Melas 1. is a managing director and global head of Equity Research at MSCI in London, U.K . (dimitris.melas{at}msci.com) In this editorial, I argue that factor investing, also known as smart beta, is having a profound and lasting impact on the way long-term investors construct

This article investigates the commonality in risk factors and sector biases in managed volatility equity strategies (both active and passive). A unique aspect of this article is that it is written from the perspective of a user of the strategies. Unlike all other past studies it considerers several versions of low volatility strategies—from different managers with different investment approaches and risk models. The findings here are therefore more general and not specific to a particular implementation or risk model. We will explore both actively managed volatility strategies as well as an index strategy.

In the past 10 years, ESG considerations have increasingly become integrated into mainstream portfolio management. A large number of long-term institutions such as pension funds, sovereign wealth funds, insurance companies, endowments and foundations have signed up to the UN Principles for Responsible Investment. Many of these institutions either make allocations to segregated ESG mandates or incorporate ESG criteria across their entire portfolio. Asset managers have responded to this increasing demand from asset owners and have started to integrate ESG into their strategies using mechanisms ranging from exclusions based on screening to full integration into the security selection and portfolio construction process.

Typical multi-asset-class portfolios can be dominated by equity risk, even when the allocation to equities is relatively modest. Achieving risk parity between equities and fixed income in an unlevered portfolio would require significant rebalancing towards fixed income. While such rebalancing can lead to a reduction in risk, portfolios with high fixed-income allocations have historically underperformed equity-dominated portfolios. However, achieving risk parity through leverage, while keeping the initial asset allocation constant, would typically require substantial levels of leverage and could lead to a significant increase in portfolio volatility. The authors combine rebalancing and leverage to construct risk parity portfolios that target the same expected return and the same portfolio risk as the initial asset allocation and examine the performance of these portfolios in different market conditions.

This article presents alternative methods for constructing factor-replicating portfolios, which include portfolios that have unit exposure to a target factor, zero exposure to other factors, and minimum portfolio risk. The authors provide empirical evidence that constrained factor portfolios, with a limited number of assets and relatively low turnover, tracked several Barra equity risk model pure factor returns reasonably well. They also illustrate how factor-mimicking portfolios could have been utilized in the past to enhance both passive and active investment strategies. Factor-mimicking portfolios can be used to hedge out the unintended factor exposures of conventional benchmarks, which are aimed at targeting a particular beta factor, and thus enable plan sponsors to better manage their optimal allocations to beta factor risks. Additionally, factor-mimicking portfolios can be utilized to hedge out the style exposures of active stock-picking strategies enabling active managers to capture pure alpha.

This article shows that portfolios that aim to diversify across countries and across industries provide markedly better reward-to-risk ratios than the traditional asset allocation strategies that aim to select country positions and then index local broad market indexes. Country asset allocations are distinctly different under each strategy. The results hold across nationality of investors, across alternative benchmarks, and across alternative currency hedging strategies.

MSCI Barra has recently published three research papers that examine the current equity asset allocation practices in the US, UK, and Japan and identify an increasing adoption of a global approach to equity allocation. This paper reviews the current strategic equity allocation policies of European institutional investors. It discusses the evidence that challenges the separation of equity policy portfolio into domestic/international allocations or regional allocations at the strategic level, and the rationale and potential benefits of an integrated global approach to equity allocation.