Factor investing and liability-driven investing are widely recognized as two major advances in asset-liability management. Factor investing, which recommends that allocation decisions be expressed in terms of risk factors as opposed to standard asset classes, has blurred the traditional distinction between passive and active investing since investors are now aware that long-term outperformance with respect to cap-weighting indices can be accessed through systematic trading strategies. In parallel liability-driven investing, which is based on two fundamental building blocks known as a performance-seeking portfolio and a liability-hedging portfolio, has replaced the traditional concept of a “policy portfolio”, which had long been dominant in institutional money management. Interestingly, both paradigms are tightly connected with advances in research on portfolio optimization and asset pricing.
To explain what role factors can play in liability-driven investing is the purpose of a new EDHEC-Risk Institute publication entitled “Factor Investing in LiabilityDriven and GoalBased Investment Solutions”, conducted as part of the “ETF, Indexing and Smart Beta Investment Strategies” research chair supported by Amundi. Specifically, the authors analyse the benefits of a factor investing approach at three stages: 1. The construction of a performance-seeking portfolio that efficiently harvests factor risk premia across and within asset classes; 2. The construction of a liability-hedging portfolio that replicates as closely as possible factor exposures driving changes in the present value of liabilities; 3. The joint measurement and management of common factor exposures in performance-seeking and liability-hedging portfolios so as to improve the interaction between the two building blocks.
The authors of the study, Lionel Martellini and Vincent Milhau, draw three major conclusions from their work:
- Factors that have a robust and economically justified long-term premium are of particular interest for the construction of a performance-seeking portfolio. A multi-factor portfolio based on the 6 most popular factors (value, size, momentum, low volatility, investment and profitability) enjoys a significantly higher reward than the standard cap-weighted index or a single-factor portfolio;
- In the liability-hedging portfolio, the relevant factors are the risk factors that explain time variation in the value of liabilities, including notably the level and the slope of interest rates. To secure replacement income for retirement, it is much safer to hold a bond portfolio with controlled duration than to invest in cash, although cash is often wrongly regarded as the “safe asset”;
- By choosing a performance-seeking portfolio with better liability-hedging properties than a standard broad cap-weighted index, investors can allocate a bigger fraction of their assets to equities without taking the risk of larger deviations or larger losses with respect to their liabilities. Starting from a 40% allocation to the broad index, the equity allocation can be increased up to about 50% without increasing the size of drawdowns with respect to liabilities, and the result is a gain in performance that ranges approximately from 20 to 120 basis points per year.
Commenting on this research, Lionel Martellini, Director of EDHEC-Risk Institute, said, “In this study we document the benefits of factor investing in both the performance-seeking and liability-hedging portfolios. We also argue that adopting a factor investing perspective offers useful new insights with a view to improving the interaction between these two portfolios. In this process we introduce a comprehensive investment framework blending liability-driven and factor investing, widely recognized as the two most significant advances in institutional money management over the last two decades.”
Bruno Taillardat, Head of Smart Beta and Factor Investing Solutions at Amundi, added: “We are pleased to support this study, which brings together factor investing and liability-driven investing into a single, comprehensive framework. Our partnership with the EDHEC-Risk Institute continues to help cement Amundi’s position as a thought leader in investment management and enhance Amundi’s strong engagement with investors looking to meet their asset allocation goals.”
A copy of the publication can be downloaded via the following link:
You can access an exclusive 2-page summary of the publication outlining the authors’ main insights here: https://risk.edhec.edu/factor-investing-liability-driven-and-goal-based
This research was supported by Amundi as part of EDHEC-Risk Institute’s “ETF, Indexing and Smart Beta Investment Strategies” research chair.
