Wealth & Finance July 2017

Wealth & Finance International 20 Factor Investing - Boosting Returns from Equity and Credit Markets factor can be thought of as any characteristic of a group of securities that is important in explaining their return and risk. How do we create exposure to factors? By tilting portfolios towards stocks or bonds that are exposed to factors such as: • Value – being cheap • Low risk – being less risky • Momentum – having strong (past) returns • Quality – being profitable Factor investing is a natural extension of quantitative investing with recent innovations involving greater transparency and robustness. New generation strategies target risk exposures to well-identified factors for which there is strong academic evidence that they have generated uncorrelated positive excess returns. In fixed-income, the low-risk premium can be found across the asset class. Whether it is government bonds, investment-grade credit, high- yield credit or even emerging market debt, low-risk bonds can generate a positive premium 1 . As with equities - factor premiums can be harvest- ed from multi-factor investing in investment-grade and high-yield credit - based on the value, low risk, quality and momentum factors using low-turnover strategies. An example - the low risk factor Low-risk stocks, which are selected using historical volatility measures, earn an attractive factor premium. Yet, it remains important to diversify the exposure across sectors. This should help steer away from a con- centration of holdings in sectors that have been found to contain many low-volatility stocks, but that have also been shown to be particularly sensitive to changes in interest rates. These would be the typical non-cyclical sectors that do poorly when interest rates rise 2 . Looking at other factors, quality reflects the strength of company profitability as well as competitive and management strength 3 . The momentum factor reflects the finding that shares of companies with the strongest past returns have generated higher future returns than those with a poorer past performance, and without being riskier 4 . Value simply refers to companies that are valued at a market price that is below what could be expected given their book value, earnings, cash flows and other equivalent measures 5 . Just pure exposure please Investors could wonder whether it makes sense to go short or under- weight expensive, high-risk and unprofitable stocks or those with the weakest past returns and overweight cheap, low-risk, profitable stocks or those with the strongest past returns in a single portfolio. We believe there is little to gain from such an effort and that it is best for strategies to be focused on straightforward long exposure to a single factor or a combination of all four. 6 We believe that investing in a multi-factor strategy beats investing in a collection of single-factor strategies, because this allows for better control of the risk allocation to each factor and better management of any con- straint. Running a multi-factor portfolio requires lower portfolio turnover and is thus more efficient. However, single-factor strategies can be useful for investors that already have factor exposures in their portfolios. At BNP Paribas Asset Management, factor-based – or smart-beta – strategies are managed by THEAM, the specialist in model-driven, indexing and capital protection investing approaches. THEAM currently employs more than 60 fund managers, product structuring experts, investment specialists and financial engineers. Teams can draw on the international marketing power of BNP Paribas Asset Management and BNP Paribas Corporate & Institutional Banking (CIB). Assets under management amount to EUR 38.2 billion (as of 31st March 2017). For more on the investment opportunities, go to www.theam.bnpparib - as, www.bnpparibas-am.com or investors-corner.bnpparibas-am.com 1 R. Leote de Carvalho, P. Dugnolle, X. Lu, P. Moulin, Low-risk anomalies in global fixed income: Evidence from major broad markets, The Journal of Fixed Income, 2014. 2 R. Leote de Carvalho, Low-risk equity strategies without interest rate sensi- tivity investors-corner.bnpparibas-am.com/thought-leadership/low-risk-equi- ty-strategies-without-interest-rate-sensitivity . 3 E. Vincent, Quality, the Positive Factor, investors-corner.bnpparibas-am.com/ investment-themes/quality-the-positive-factor 4 E. Vincent, Momentun, the Unloved Factor , investors-corner.bnpparibas-am. com/investment-themes/momentum-the-unloved-factor 5 E. Vincent, Value, the Obvious Factor, investors-corner.bnpparibas-am.com/ investment-themes//value-the-obvious-factor 6 R. Leote de Carvalho, X. Lu, F. Soupe, P. Dugnolle, Diversify and Purify Factor Premiums in Equity Markets in Factor Investing and Alternative Risk Premia, editor Emmanuel Jurczsenko, ISTE and Elsevier, October 2017 When traditional asset classes are expected to deliver low returns, diversification into uncorrelated sources of return can help investors. Factor – or smart-beta – investing involves exactly that: creating portfolios around factors that can be expected to generate positive returns over the long run that are uncorrelated with the returns of the traditional asset classes. A 1612WF18