Utilising quant in equity portfolios to improve returns, avoid unintended risk and integrate sustainability
Global Investment Insights
with Scott Bennett, Head of Quantitative Investment Solutions, APAC, Northern Trust Asset Management
Scott Bennett is Head of Quantitative Investment Solutions, APAC at Northern Trust Asset Management where he is responsible for the development and support of the organisation’s quantitative solutions across both Australian and global equity markets.
Scott shares how he and his team are working with clients to help improve returns, reduce risk and integrate sustainability through a time of heightened inflation and uncertainty, and how investors can navigate their portfolios through this environment to achieve their desired return outcomes in the long-run, in this exclusive interview with Global Investment Institute (GII).
Q . What are the main areas of focus for you currently in your role as Head of Quantitative Investment Solutions – Asia Pacific at Northern Trust Asset Management?
In my role I lead a talented team of investment analysts that are focussed on working with our clients to best utilise our global quantitative platform to improve returns, avoid unintented risk and integrate sustainability. The main areas of focus for us, and our clients, currently is the integration of sustainability considerations with traditional equity factors.
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We are positioning our portfolios at the intersection of sustainability and profitability.
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We are looking comprehensively at the risks and opportunities presented as a result of the transition away from fossil fuels towards renewables and positioning our portfolios at the intersection of sustainability and profitability in order to deliver solutions that are focussed on delivering double materiality for our clients. We recognise that the pathway to net-zero will not be a straight line and that we need to look at sustainability data that is both historically aware and forward looking. Our research has highlighted that both risk and return outcomes can be improved through integration of both financial and non-financial data sets.
In addition, a key focus has been working with our clients to ensure that multi-factor portfolios achieve effective and robust diversification. Following the impact of COVD-19 across equity markets in 2020 we have undertaken a review of the drivers of risk across factors and investigate the impact on portfolio construction approaches designed to equalise risk contributions. To this end we have been building a proprietary risk model that is designed to provide more robust risk estimates and allow for greater understanding of key risk drivers and a clearer attribution of risk.
Q. What is driving equity market valuations currently and how do you view where valuations sit relative to fundamentals?
Market valuations have normalised in 2022 following the post-pandemic peaks we saw at the end of 2021.
Rising interest rates are definitely having a significant impact on valuations. Specifically, rising rates have resulted in a de-rating of high growth companies across the market. This has coincided with strong returns for value companies over the past 12 months. We regularly review valuations of different styles and factors across the market.
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With the backdrop of monetary policy tightening and heightened market volatility, we favour factors such as value, momentum, quality and low volatility because our analysis shows that historically, these factors have fared well in similar market environments.
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Our approach to measuring relative value is through a double relative valuation model, which considers a factors’ current valuation relative to the broader market and what the valuation looks like relative to its long term average. At any point in time we generally see one or two factors looking relatively expensive and one or two factors looking relatively cheap. For example, through the pandemic we saw both Momentum and Low Volatility trading relatively expensive and Value trading relatively cheap. However, we are currently in a unique environment where all the factors we consider are trading close to their long term expectations, which highlights that we don’t see crowded factor trades in the market. Combining this with the backdrop of monetary policy tightening and heightened market volatility, we favour factors such as Value, Momentum, Quality and Low Volatility because our analysis shows that historically, these factors have fared well in similar market environments.
Q. How can long-term investors successfully navigate global equity markets through an inflationary environment?
High inflation environments present a number of challenges to investors, across multiple asset classes and in 2022 we have seen the impact of high inflation on both equity and bond market volatility. The current inflationary regime has been constructive for style factors, particularly value-oriented and defensive strategies.
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Aggressive monetary tightening and falling energy prices have investors wondering if an inflation reversal is imminent.
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Recently, aggressive monetary tightening and falling energy prices have investors wondering if an inflation reversal is imminent, and whether the outlook for style factors has diminished. Our analysis indicates that factors have performed well historically throughout the full inflationary episode, and that reaching peak inflation is non-consequential to expected factor returns. This finding is particularly noteworthy for value investors who have become conditioned to believe that value cannot outperform in a declining rate environment. There are also emerging trends as corporate demand for ambitious carbon reduction strategies grow.
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Value investors have become conditioned to believe that value cannot outperform in a declining rate environment.
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While average factor returns do not materially change throughout the inflationary episode, the dispersion of factor performance increases considerably as inflation transitions into a lower inflationary regime. This has implications for tactical investors as downside risk becomes elevated. We recommend a balanced, multifactor strategy as an alternative to factor timing. We believe this approach mitigates the downside risk associated with any individual factor while retaining much of the upside potential.
Q. What drives equity market returns in the long-run? If inflation persists, how can long-term investors minimise its impact on their portfolios?
The biggest challenge that inflation presents is that it raises the hurdle on the required rate of return for investors. Over the past two decades we have had relatively benign inflation and this has also coincided with a big shift away from active management to passive asset class exposure, as inflation based targets have been easily achieved through diversified market exposure. As we move into a more persistent high inflation environment, investors will need to look beyond passive market exposure to achieve their longer term investment objectives.
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As we move into a more persistent high inflation environment, investors will need to look beyond passive market exposure to achieve their longer term investment objectives.
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Our own research, along with numerous academic studies, shows that factors such as Value, Momentum, Quality and Low Volatility provide investors with returns over and above a traditional passive equity exposure. The ability to gain systematic exposure to these proven return drivers will be critical to enabling investors to achieve their long term return targets. However, we note that gaining access to these return drivers is not straightforward and investors need to ensure they are targeting compensated risks such as Value, Momentum and Quality) and avoiding exposure to uncompensated risks in their portfolios, such as sectors and countries.
Q. What themes or trends do you seek to capture in your global equity portfolios in pursuit of long-term targeted return objectives?
A key trend we are seeing from investors is an increased emphasis on risk, with investors wanting to ensure they understand the risks they are taking, while being compensated for the risk they take, in all market environments. Over the past two years, we have seen elevated risk in the equity market, both at the total market level and also across sectors.
The heightened level of sector volatility has resulted in sector and regional exposures having a much greater impact on returns than usual. With investors worried about inflation, monetary tightening, supply chain disruption and geopolitical tensions, we are seeing overwhelming demand from investors to build portfolios that use risk as efficiently and transparently as possible. In essence, the risk in the portfolio is coming from factors that have been proven to be more persistent sources of excess return or risk-adjusted returns, such as Value, Quality, Momentum and Low Volatility.
In addition, we continue to see sustainability as a key trend for investors, with an emphasis on aligning portfolios with net zero emission goals. Investors are looking for investment solutions that can fully integrate sustainability into portfolio positions.
Typically, simplistic approaches to sustainability that focus on exclusions have really been tested in 2022, as the energy sector has been the strongest performing sector. Again, a key emphasis here is investors need to control for risks, like sector and/or region, that don’t consistently add value, and look to achieve their objectives by drawing from all areas of the investable universe.
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Typically, simplistic approaches to sustainability that focus on exclusions have really been tested in 2022, as the energy sector has been the strongest performing sector.
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Scott presented on how to navigate equity portfolios through the current inflationary environment at Global Investment Institute’s 2022 Equities & Growth Assets Investment Forum, which took place on Wednesday, 7 September 2022 at the Westin, Melbourne CBD, Victoria.
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Scott Bennett, Head of Quantitative Investment Solutions, APAC, Northern Trust Asset Management
Scott Bennett is head of quantitative investment solutions, APAC where he is responsible for the development and support of Northern Trust Asset Management’s quantitative solutions across both Australian and global equity markets. Scott drives thought leadership and works with large institutional clients on customised quantitative solutions.
Scott has more than 18 years of investment experience. Prior to joining Northern Trust Asset Management, Scott led the global quantitative research effort at Russell Investments, where he was responsible for more than $45 billion in assets under management across single factor, multi-factor, factor timing, environmental social and governance (ESG), and portfolio completion strategies. He was previously responsible for managing more than $7 billion in Australian equity portfolios that included after-tax, smart beta and multi-manager strategies.
Scott earned his bachelor’s degree in business (economics and finance) with distinction from RMIT University and a master’s in finance (applied finance) from the University of New South Wales (UNSW).
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