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"The best thing you can do ... is listen": Q&A with Northern Trust's Head of Quantitative Research September 2019
Scott Bennett has been with Northern Trust Asset Management for just over a year and is head of quantitative research and client solutions, Australia and New Zealand. He speaks with Industry Moves about Northern Trust's factor-based approach to investing and why it is particularly important in a concentrated market like Australia. He also tell us why he likes quantitative investing and how the best career advice he ever received was to 'be a sponge'.
- What are the benefits of factor-based investing?
Factor based investment strategies utilise systematic portfolio construction techniques to provide consistent and persistent exposure to well documented drivers of equity returns. These return drivers include; Value, Momentum, Quality and Low Volatility.
The key benefits that are attracting investors to factor-based investment approaches include:
- The opportunity to improve returns;
- The ability to target specific outcomes (i.e. low volatility);
- Greater transparency and consistency of the investment process; and
- Typically lower cost than traditional active management.
- What are some of the challenges to factor-based investing in Australia?
Australia is a highly developed equity market, however the dynamics and micro-structure of the Australian equity market are vastly different to that of the US and global equity market. The big challenges we see for factor-based investing in the Australian equity market are:
Market concentration: The Australian equity market is one of the most concentrated in the developed world at both the stock and sector level. The Australian equity market is approximately 10 times more concentrated than US and global equities. Due to the concentrated nature of the Australian equity market, traditional portfolio construction techniques carry significantly more active risk than they do in diversified markets (US and global equities).
Sector dominance: Not only is the Australian market concentrated at a security level, it is also highly concentrated across sectors. In the S&P/ASX 300 Index, financials and materials comprise more than 50 per cent of the market, whereas these sectors represent less than 20 per cent of the global market. The Australian equity market has a heavy concentration in financials that we believe is too big to ignore, and it is extremely important to account for this in both factor design and portfolio construction.
Small cap variability and cyclicality: Over the past 15 years, the maximum underperformance of Australian small companies (represented by S&P/ASX Small Ordinaries Index) in a 12-month period was -32 per cent, which is roughly two and five times higher than US and global equities, respectively. Typically, traditional factor-based strategies tend to carry a meaningful bias towards small companies. For Australian equity factor strategies, if the size exposure is not managed, it could result in the targeted factor premium being swamped by an unintended small cap allocation.
- How can these be overcome?
We believe the opportunity for factor exposures is just as powerful in Australian equities as US and global equities. However, we are aware that to be successful in markets like Australia the factors need to be robustly specified and the portfolio construction needs to be purposeful and minimise uncompensated exposures.
Our factor-based strategies seek to overcome the big challenges in the Australian market by designing our factors to be sector specific. We recognise that business models across sectors are so dissimilar, they require different factor definitions. For example, we can’t use the same criteria to judge the quality of a REIT, a bank, and a resources company.
Further, when positioning toward any factor, there is a strong tendency to take unintended and potentially uncompensated or even negatively compensated biases to certain sectors, or other style factors and stock specific risk. These uncompensated risks are generally greater in markets like Australia. Our advanced portfolio construction techniques aim to minimise exposure to uncompensated risks across our strategies to improve the efficiency and efficacy of our strategies.
"To be successful in markets like Australia the factors need to be robustly specified and the portfolio construction needs to be purposeful and minimise uncompensated exposures."
- How does factor investing achieve more efficient risk-adjusted returns?
As our research highlights, the payoffs for different factors are highly cyclical and these cycles can be quite extended. Fortunately, the payoffs among factors tend to have a very low correlation amongst each other. This presents a fantastic opportunity for investors to combine factors to further reduce active risk and increase risk adjusted returns.
The relatively low tracking error, high information ratios, higher transparency and lower cost represent an attractive core equity exposure.
- Why is a high-conviction approach important for factor investing?
Our multi-factor portfolio utilises a high conviction, integrated and bottom-up approach to portfolio construction. This approach focuses on only those securities that display positive attributes across all the factors that we are targeting.
Our research has shown that taking a high conviction bottom-up approach to building a multi-factor portfolio in Australian equities can add over 0.7 per cent per annum to the realised excess returns over time, relative to a top-down allocation to different factor sleeves. This leads to higher information ratios and improved outcomes for investors.
- Where does a factor-based approach to investing fit into a portfolio?
Factor-based strategies can be quite flexible in their utilisation. We typically see factor-based strategies as a core strategy within a portfolio and also used as a great compliment alongside traditional active and passive management. Factor-based strategies can play a key role for outcome based investors and specifically in helping to manage volatility and other risks across not just an equity portfolio, but also a multi-asset portfolio.
"We typically see factor-based strategies as a core strategy within a portfolio."
- What do you like about quantitative investing?
I spent the early part of my career researching the best fund managers in the industry and I found it absolutely fascinating to see the uniqueness in their approaches. I have never been a great stock picker and have always been trying to figure out ways that I could “bottle” or systematise some of the active management magic. Quantitative investing was a natural fit for me.
The big attraction for me to quantitative investing is the ability to be relatively more objective (although no investment process is ever completely objective) in identifying opportunities and more disciplined in applying the investment process.
- What advice would you give somebody starting out in investment management?
The best advice that I could give someone starting out in the investment management industry is the advice that I received when I first started… “be a sponge… and take it all in”. There are so many smart people in our industry, the best thing you can do at any stage of your career is listen. I think the quote goes something like “first seek to understand, then to be understood”.
In complete honesty, I haven’t always heeded that advice and upon reflection I would have been better served by doing so.
Download Northern Trust Asset Management's latest whitepaper, which explores the efficacy of factor investing in the S&P/ASX 300.
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