Factor investing: Q&A with MSCI’s Hitendra Varsani

Apr 13th, 2017 | By | Category: ETF and Index News

With over 900 ETFs based on its indexes, MSCI is one of the most important index providers in the ETF world. The firm calculates over 180,000 indexes daily with over $10 trillion in assets benchmarked to those indexes. ETF Strategy sat down with Hitendra Varsani, who spent 11 years at Morgan Stanley prior to joining MSCI as executive director of factor strategies.

Hitendra Varsani, executive director of factor strategies, MSCI

Hitendra Varsani, executive director of factor strategies, MSCI.

The factor index landscape is becoming increasingly crowded. How does MSCI set itself apart from its competitors?

There are over $180 billion in assets benchmarked to MSCI factor indexes and over 190 equity ETFs that track MSCI factor indexes, so we take the underlying data that we use to construct our indexes very seriously. MSCI revolutionized factor investing – starting with Barra factor models in the 1970s.  We have the largest research team in the industry and follow a very rigorous data cleansing methodology, which provides an unparalleled data set with which to conduct historical analysis. In addition, our factor strategies are rooted in academic research to provide optimal exposure to factors that are proven to give significant excess returns in a range of markets over long time periods.

MSCI prefers the term factor investing to smart beta – why?

Factor investing and smart beta refer to roughly the same thing but here at MSCI, we see smart beta as more of a marketing add-on which can potentially be confusing for investors. The use of the term factor investing is consistent not only with the body of academic literature on the subject, but also with the Barra fundamental risk factor models developed for portfolio risk management. Factors describe the underlying drivers of risk and return of securities. The six factors MSCI has identified – Value, Low Size, Low Volatility, High Dividend Yield, Quality and Momentum – are factors that most investors are familiar with and have all been shown in numerous empirical studies to give excess returns over long time horizons.

How have different factors performed over the past year?

Last year proved to be a very interesting year for factor performance. The abrupt nature of the risk-off to risk-on switch in sentiment halfway through the year caused correlations within defensive factors and cyclical factors to rise to extreme levels. In the first half of last year, we saw defensive factors outperforming, with Low Volatility and High Dividend Yield doing particularly well. In the second half of 2016, factor performance reversed so that by the end of the year, much more convergence was seen between returns of factors over the entire year. The pickup in the global economy caused cyclical factors such as enhanced value and size to outperform in the second half of the year, a trend that was amplified by the result of the US election.

What are your expectations of factor performances going forward?

Factor timing is akin to market timing – very difficult to do. What MSCI research shows is the historical sensitivity of factors to different macro conditions. As you would expect, the factors typically thought of as defensive, being Low Volatility, High Dividend Yield and Quality, perform relatively better when leading economic indicators are in decline, and the cyclical factors of Value and Size perform better when the same indicators are rising. Momentum on the other hand, has outperformed when economic indicators are either rising or falling, but tends to perform best when the speed of change is gradual.

Most commentators believe growth and inflation will rise in 2017, which might be the reason we have seen a big pick up in interest for our Value indexes. But what we at MSCI can do is dig much deeper into the data and say, for example, that when inflation and growth both rise steeply, Value is likely to be the best performing factor, but when growth rises sharply and inflation rises more gradually, Momentum has historically been the factor that delivers the highest returns.

In the end, the ideal factor allocation at any time depends not only on specific investment goals but also on your view of future economic conditions.

Multiple-factor strategies are growing in popularity, which is an excellent way of smoothing out the cyclical nature of returns seen in single factor strategies, nullifying the impact of market timing.

Factor indexes have been a big hit with investors in recent years. Where do you see future growth in client demand?

The globalization of investing is a trend that will continue. Clients are leading the trend to decrease country bias and invest in indexes that capture the whole world – such as MSCI ACWI or factor indexes based on a specific markets, for example Emerging Markets. We also think there is room for development in the multiple-factor index space. One thing that MSCI is very passionate about is ESG and we now have over 150 researchers working on ratings for global companies on a range of ESG metrics. One of the most exciting areas is the combination of ESG and factor strategies. MSCI research indicates that investors should be able to significantly increase the ESG rating of their factor strategies with a relatively modest impact on target factor exposure and returns. This is especially true for defensive factors, which are positively correlated with ESG characteristics. In general, I think a broadening of the types of indexes on offer will give investors more granular control over their investments and benchmarks.

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