The author describes an approach to constructing a portfolio that is “passive but dynamic” and “index but active,” whereby investors only pay for active management that produces excess returns that are not achievable passively. The approach begins with the investor looking at assets as bundles of risk factors. The author deconstructs the concept that assets earn returns because of underlying exposures to factor risks. Fund benchmarks for managers should be customized using long and short dynamic factors as well as static, long-only bond and equity factors.

The author’s research is in response to the public reaction to Norway’s sovereign wealth fund performance during the 2007–09 financial crisis. Norway’s citizens were upset that the active management component of the fund did not add value over the benchmark return during this period, and they questioned the value of the fees paid to the fund’s manager, Norges Bank Investment Management (NBIM). The author and two other academics evaluate NBIM’s performance and investing strategies given the particular characteristics of Norway as an investor of its citizens’ oil and gas wealth.

A large part of the sovereign fund’s active returns can be explained by systematic factors that could have been accessed less expensively through passive management. Such factors as value/growth, momentum, illiquidity, credit risk, and volatility deliver a premium to reward investors for enduring losses during bad times. The author contends that in very large portfolios, most excess returns are related to factors—about 70% in the case of Norway’s sovereign fund. Excess returns from mispricing opportunities and security selection become more difficult to achieve as the portfolio grows.

The author recommends the use of dynamic factor investing, which often involves leverage, and the inclusion of short and long dynamic factors in a large fund’s benchmarks, as well as static, long-only bond and equity factors. Many of these dynamic factors will involve more than one asset class, with the assets being bundles of underlying risk factors rather than discrete entities. The fund manager’s goal is to use the least expensive strategy to optimize the factor exposure.

According to the author, if investors decide to pursue a risk–return strategy that is different from the average (i.e., the market), they must first define how they differ from the average investor and what their risk-bearing capacity is with respect to the various factors. Ideally, such investors would have investor-specific benchmarks against which to evaluate active return.

Factors are not static, and there is no standard, generally accepted set of factors that can be removed from active return. The author posits that to be relied on, a factor should be justified in the literature, have exhibited significant premiums that are expected to continue, have a return history available for bad periods, and be implementable in liquid, traded instruments.

He describes the Canadian Pension Plan Investment Board’s version of factor investing. In addition, he relates factor investing to the capital asset pricing model and provides examples of dynamic factor allocation and dynamic factor benchmarks. The goal of factor investing, in his view, is to ensure that the returns achieved by active managers are higher, net of fees, than what can be obtained through low-cost dynamic factor benchmarks.

This evaluation would likely be valuable to government and other executives as well as institutional fund managers. It would be interesting to see how it applies to other institutional portfolios operating under different constraints. The article is part of a larger work and contains references to concepts described in other chapters within the larger work. Investment professionals would probably be familiar with the concepts cited.