The Rise of Factor Investing For Insurers


What are factors?
Factors are broad, persistent drivers of return. There are macroeconomic (macro) factors and style factors. Macro factors like economic growth and the rate of inflation help explain returns across asset classes.

In contrast, style factors help explain returns within asset classes. Style factors can be shared characteristics (e.g. attractive Value, small Size or high Quality) or returns patterns (e.g. strong Momentum or low beta).

While the concept of factors isn’t new, the use of factors is being revolutionized by technology. Advances in financial analytics and big data make it possible to quickly screen large volumes of market data and build factor portfolios with precision.

For more than 20 years, Exchange Traded Funds (ETFs) have simplified the way institutional investors access global markets. Insurance companies around the world are taking note and rapidly embracing ETF strategies. ETF assets on insurance company balance sheets in the U.S. grew by more than 70% over the past two years.1 Equity allocations represent the largest share of total insurance company ETF assets, though the use of bond ETFs by insurers is accelerating.1

Equity ETFs have been at the core of insurance portfolios for years, offering accessible market cap weighted indexes. Some of the most highly used equity ETFs include core exposures such as the iShares Core S&P 500 ETF (IVV) and iShares Core High Dividend ETF (HDV). In parallel, insurers lead the way amongst institutions in implementation of factor strategies and in doing so, they increasingly use ETFs as a delivery vehicle for factor exposures.

To understand institutional usage of factors and factor-based strategies, the Economist Intelligence Unit, on behalf of BlackRock, conducted a global survey of 200 executives from institutional investment firms, including 50 insurers. The survey found that across the institutional landscape, insurance companies were most likely to use single and multifactor equity strategies. Their leading motivator was a desire to increase return within a specific asset class. Other important drivers influencing factor strategy use included risk management, portfolio diversification and investment cost reduction.2

BlackRock identified four common themes in the implementation of factor-based equity ETFs within insurance general accounts:

  1. Building diversified income-oriented equity portfolios with dividend ETFs
  2. Managing equity risk contribution with minimum volatility ETFs
  3. Implementing factor views and portfolio tilts with single factor ETFs
  4. Multifactor ETFs: Capturing Potential Excess Returns at a Lower Cost

1. Building Diversified Income-Oriented Equity Portfolios with Dividend ETFs
Persistently low interest rates are making it difficult for insurance companies to meet yield and income targets. Since the financial crisis, U.S. and European insurers lost $400 billion in yield income.3 Among the largest U.S. insurers, average net investment income as a percentage of cash and invested assets declined by approximately 143 basis points.4

Within fixed income, insurers are taking on more risk. As book yields converge toward lower market yields, many insurers have rotated out of fixed income and cash and into equities and Schedule BA assets (a proxy for alternative investments).

Within public equities, insurers continue to increase their exposure to high dividend stocks. While many insurers have in-house expertise in selecting domestic dividend stocks, many lack the resources to identify idiosyncratic opportunities outside of the U.S. As a result, those who find it difficult to both maintain their strategic asset allocation and achieve the yield targets of their equity portfolio are turning to ETFs to access diversified, low-cost, international or global yield-oriented strategies.

Dividend ETFs: Surprisingly Varied
Dividend ETFs can vary significantly in how they select stocks. For example, iShares International Select Dividend ETF (IDV) tracks an index that selects only stocks that have a three-year history of paying dividends, subject to screens for dividend-per-share growth rate, non-negative trailing 12-month earnings and liquidity. In contrast, iShares International Dividend Growth ETF (IGRO) tracks an index that selects only stocks that have a five-year history of increasing dividends, positive consensus earnings forecasts and reasonable dividend payout ratios.

Case Study: Enhance Dividend Yield
One insurer was seeking to maintain an existing allocation, while combining high dividend yielding international equity ETFs with their internally-managed U.S. equity holdings. This investment team’s portfolio combined a U.S. portfolio of high-conviction dividend stocks with high dividend paying European, Asian and Emerging Market focused ETFs, and weighted each region to match the MSCI ACWI ex USA Index. This allowed their research team to focus on a core competency, U.S. equities, while giving them access to a basket of global dividend- paying stocks. In doing so, they increased their dividend yield by approximately 70%.

Select iShares Dividend Funds
DVYE iShares Emerging Markets Dividend ETF
DVYA iSharesAsia/Pacific Dividend ETF
IGRO iShares International Dividend Growth ETF

2. Managing Equity Risk Contribution with Minimum Volatility ETFs
As they boost equity allocations while maintaining finite risk budgets, insurers must deliberately control equity risk contribution. This focus comes with good reason, given the vastly different risk profile of equities compared to fixed income.

While the average insurance company’s equity allocation remains relatively small as compared to fixed income, equities typically contribute a disproportionate level of risk. At year-end 2016, the P&C industry’s average allocation to equities was about 8%, yet it contributed approximately 20% to total portfolio risk5. The example below illustrates how a small increase in equity allocations to 12% can have an outsized impact on its risk contribution (Figure 2). To avoid such a significant increase in equity risk contribution, some insurers are deploying minimum volatility equity strategies.

By replacing a portion of an existing equity allocation with minimum volatility, an insurer can maintain its target capital allocation while also pursuing its yield or growth objectives over the long run. On average, minimum volatility strategies have captured significantly more upside than downside (see Figure 3). Although these lower-beta portfolios often trail when equity market returns are high and risk is low, their asymmetrical market participation has tended to produce higher risk- adjusted returns and absolute returns similar to the broad market over the long run (see Figure 4). This can release risk budget to deploy in other parts of the portfolio while maintaining equity return potential.

Minimum Volatility
Minimum volatility strategies are optimized to reduce exposure to the volatility risk factor while maintaining the sector, country and style characteristics of the broad market. While some approaches may simply underweight volatile stocks, which may result in unintended exposures, the iShares Minimum Volatility ETFs are deliberately constructed to be precise tools with which to target low volatility.

The historical tendency of minimum volatility strategies to deliver better risk-adjusted returns is driven by two forces.

Structurally, lower-risk stocks tend to be relatively underpriced as leverage- constrained investors purchase more high risk stocks to meet return ambitions.

Behaviorally, lower risk stocks are often overlooked as investors pursue risky stocks, overestimating the probability of dramatic outperformance. This behavior is known as the “lottery effect”.

Case Study: Reduce Equity Risk
In one illustrative example (see Figure 5), a P&C insurer looking to reduce equity risk partnered with BlackRock to analyze its exposure to a variety of risk factors. The insurer’s equity exposure consisted of a 15% allocation to large-cap U.S. stocks, with the remainder of the portfolio invested across various lower-risk fixed income sectors. After examining the risk-contribution of each asset class, the insurer found that equities contributed 37% of total portfolio risk. Despite the high risk contribution of the equity allocation relative to its weight in the portfolio, the insurer sought to maintain its allocation to the asset class.

The proposed solution encompassed replacing the allocation to large-cap U.S. equities with a minimum volatility U.S. equity ETF, such as iShares Edge MSCI Min Vol USA ETF (USMV). The analysis showed that this adjustment potentially reduced the equity risk of the portfolio by 21% (from 37% to 29%) while also maintaining large-cap exposure. This reduction allowed the firm to deploy risks in other parts of the portfolio.

3. Implementing Factor Views and Portfolio Tilts with Single Factor ETFs
Similar to single country and sector ETFs, factor-based ETFs allow investors to efficiently orient their portfolios based on macroeconomic views while providing diversification and liquidity potential. Whereas single country and sector ETF index methodology selects constituents based on static characteristics such as company domicile and revenue source, factor-based equity ETFs select stocks based on their historical drivers of return. Value, Size, Quality and Momentum are time-tested drivers of returns across equities. Because different economic rationales typically drive each factor, they have tended to outperform at different times. For investors with a shorter time horizon and a reasonable appetite for risk, this cyclicality presents an opportunity to tilt portfolios towards one factor or another in pursuit of incremental returns (see Figure 7 below).

Investors may also blend factors in order to gain exposure to a set of risk premia that provide outperformance over time. Such an approach takes advantage of the potential diversification benefits and the time varying nature of factors, without tying the portfolio to the performance of any individual factor. This also affords investors the opportunity to determine their own strategic asset allocation of factors, thereby harnessing the low (and often negative) correlation of excess returns relative to each other, as seen in figure 8 below.

Four Style Factors
Value, Size, Quality and Momentum have been historical drivers of equity returns. Each factor is easily accessible through iShares single factor ETFs: VLUE, SIZE, QUAL, MTUM

Indexes select constituents based on certain characteristics associated with each factor:

VLUE Value: High book value to price, high 12-month forward earnings to price and enterprise value to cash flow from operations.
SIZE Size: Small market capitalization.
QUAL Quality: High return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
MTUM Momentum: High price momentum.

Case Study: Rethink Core Allocations
One large P&C insurer embraced this approach in its surplus portfolio, replacing part of its passive U.S. market capitalization-weighted equity allocation, in the form of iShares Core S&P 500 ETF (IVV), with a blend of factor- based ETFs representing Quality, Momentum, Value and Size (see Figure 9). Initially, the investment team equally weighted its allocations to each of the factors, deliberately avoiding tactical views on any one factor while retaining flexibility to tilt the portfolio at different points in the business cycle.

Over time, as the market environment changed and the investment team identified signals of an expansionary cycle, the insurer increased its relative allocation to the Value and Size factors using iShares Edge MSCI USA Value Factor ETF (VLUE) and iShares Edge MSCI USA Size Factor ETF (SIZE). The MSCI USA Enhanced Value Index (the benchmark for VLUE), has a historical upside capture in excess of 100% and a beta greater than one, while the MSCI USA Risk Weighted Index (the benchmark for SIZE) offered risk- managed exposure to smaller companies and a greater upside than downside capture ratio.6 In combination, these two factors have generally outperformed in periods of economic growth, an opportunity the insurer sought to capture.6 While Value and (small) Size were overweighted, the insurer maintained diversification with relative underweights to Momentum and the slightly more defensive Quality factor.

As market signals changed, the insurer implemented a more defensive tilt, executing an overweight to Quality via the iShares Edge MSCI USA Quality Factor ETF (QUAL), relative to the other three factors. With a methodology designed to seek out stocks with strong balance sheets and stable earnings, the MSCI USA Sector Neutral Quality index (the benchmark for QUAL) had a historical beta of 0.9 and a maximum drawdown 14% less than that of the S&P 500.6 The investment team continues to monitor market signals to tilt the portfolio tactically.

Why Use a Multifactor Strategy?
Multifactor strategies are optimized to provide diversified exposure to several factors. Individual style factors may zig while the others zag depending on the market environment, so a portfolio that uses a multifactor approach can potentially benefit in a variety of market conditions, harnessing their negative correlations (see Figure 8). Over the long term, combining factor exposures may produce even more consistent results than factor exposures individually.

Multifactor equity funds such as the iShares Edge MSCI Multifactor USA ETF (LRGF) can have sector, country and risk characteristics that are similar to well-known equity benchmarks, so these funds can function as long-term core allocations.

4. Multifactor ETFs: Capturing Potential Excess Returns at a Lower Cost
While some insurers take an active approach to implementing single factor views, many others choose to embrace the diversification benefits and potential return enhancement that can come from an allocation to a diversified set of factors through a multifactor strategy.

In particular, multifactor ETFs provide a flexible solution for insurers who are looking to replace active managers and reduce management fees. Insurers increasingly engage portfolio analysis technology such as factor-based attribution tools to identify static drivers of active manager performance. In some cases, this separates managers that are consistently delivering alpha over time from those that maintain relatively static allocations to factors (now accessible more cheaply through ETFs). Static exposure to factors explains over 90% of the aggregate excess returns among outperforming managers.7 While true alpha (i.e. excess return that is driven not by factors, but by security selection or timing) may still be present in addition to static factor returns, it can be reduced by the drag of high fees. Multifactor ETFs enable insurers to mirror much of the risk exposure in certain active funds, at a lower price.

The rules-based indexes that underlie single and multifactor ETFs have evolved to deliver precise exposure to these historically rewarded risk factors across various global equity markets. These factor indexes are transparent (holdings disclosed daily) and based on published rules that can help increase predictability of turnover and performance. Multifactor indexes use bottom-up stock selection and weighting to maximize exposure to desired factors while minimizing overlap. Ultimately, these factor indexes enable insurers to build ETF portfolios with potentially higher risk-adjusted or absolute returns versus the market, at a lower cost than active managers.

Case Study: Manage Factor Exposure
An insurer sought to decompose one of its active U.S. equity manager’s sources of excess return. The manager delivered slight outperformance of 39 basis points per year versus the benchmark (S&P 500) net of fees. With support from BlackRock, the insurer conducted a factor-based risk analysis and return attribution on the fund. This analysis, based on 5 years of holdings, illustrated the manager’s persistent factor tilts over time (Figure 11).

Looking Ahead
The insurance industry has seen significant shifts in the way investment teams direct asset allocation to maximize risk-adjusted returns and income, while reducing volatility against a backdrop of regulatory and market-driven constraints. Though a significant proportion of risk in insurance portfolios stems from rates and spreads, the growth of equity and alternative allocations add another layer of complexity to the risk-budgeting process. Insurers must deliberately redistribute risk while seeking to maintain or boost portfolio return. Given expectations for continued low rates, low expected equity returns, and an expected pickup in market volatility, this trend is likely to persist.

In this context, ETFs can be useful tools for insurers to steer portfolios. BlackRock partners with insurance companies to share insights into portfolio risk and return analytics, investment due diligence, and trading guidance. We are here to help.

By BlackRock
Joshua Penzner, Managing Director | | 212-810-5376
Ana Morales, Director | | 212-810-8373
Paul Arendt, Director | | 415-670-2183

1Source: U.S. statutory data from S&L Finance, as of 12/31/17. 2Source: The Economist Intelligence Unit, as of 1/31/16.
3Source: Swiss Re, “Financial repression: The unintended consequences”, March 2015.
4Source: BlackRock, as of 12/31/16.
5Source: BlackRock Solutions, as of 12/31/16. Risk represented by 95% Value at Risk (VaR); VaR is calcu- lated at a 95% confidence interval; 180 monthly observations, constant weighted. P&C industry excludes Berkshire Hathaway and State Farm.
6Source: BlackRock, MSCI, Morningstar, 1/1/2015 – 3/31/2018 based on monthly return. Past performance does not guarantee future results.
7Source: Madhavan, Sobczyk, Ang (2016) “Estimating Factor Exposures with Cross-Sectional Characteristics with Application to Active Mutual Funds”, BlackRock Working Paper.
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