M A R K E T SM A R K E T SI N V E S T M E N T

A C T I O N SP O R T F O L I O

D E S I G NR I S K

M A N A G E M E N T R E G U L A T O R YM A R K E T SI N V E S T M E N T

A C T I O N SP O R T F O L I O

D E S I G NR I S K

M A N A G E M E N T R E G U L A T O R Y

A MATTER OF STYLETHE LONG AND THE SHORT OF

STYLE FACTOR INVESTING

SEPTEMBER 2016

[ 2 ] A M A T T E R O F S T Y L E

Executive summary

} Style investing has become increasingly prominent, most notably in long-only equity strategies, often known as smart beta, which can be an efficient and cost-effective means to target incremental returns or reduced risk within equity allocations.

} However, the true power of style investing can be more fully realized through a long/short, multiasset strategy that invests across multiple factors in multiple markets. Employing a long/short approach across asset classes can create a powerful source of diversification in institutional portfolios.

} Our approach to style investing focuses on factors that make intuitive economic sense, demonstrate the ability to create value for investors, provide a source of diversification and can be implemented efficiently.

} We target four investment styles that we believe can deliver long-term returns and diversification across multiple asset classes: value, carry, momentum and defensive.

} In order to harness the power of style factors in investment portfolios, it is critical to emphasize economic intuition (and beware of data mining), to build exposures carefully in order to target only the desired risks, and to manage implementation effectively.

} We believe that style factors will play an increasingly important role for a variety of institutions in the years ahead, and that investors will come to view the holistic, multiasset approach to style investing as a valuable tool for pursuing diversifying sources of return in a low-return and higher-volatility climate.

Ked Hogan, PhD Head of Investments for BlackRock’s Factor-Based Strategies Group

Phil Hodges, PhD Head of Research for BlackRock’s Factor-Based Strategies Group

Ted Daverman, CFA Researcher, BlackRock’s Factor-Based Strategies Group

T H E L O N G A N D T H E S H O R T O F S T Y L E F A C T O R I N V E S T I N G [ 3 ]

The rise of factor investing is reshaping the investment landscape. While risk management has long employed factor models, many investors are now looking to factors as a potential means to enhance returns. In an Economist Intelligence Unit survey1 of institutional investors released in April 2016, 60% of participants said they plan to increase their use of factors or factor-based investment strategies over the next three years, with the desire to improve returns cited as one of the most important motivations.

Rules-based smart beta strategies are probably the most widespread form of factor investing. The majority of these are long-only equity strategies targeting style factors such as momentum or value, and they can be an efficient and cost-effective means to target incremental returns or reduced risk within equity allocations.

However, we believe the true power of style investing can be more fully realized through a holistic, long/short, multiasset strategy. In this paper, we present our views on how to implement such a strategy—and on why style factors can be particularly useful tools for targeting increased return and reduced risk in a challenging investment climate.

Since the industry has yet to settle on a standard terminology for factor investing, we set the stage by laying out our framework, starting with a definition: Factors are the broad, persistent drivers of return that underlie all asset classes, and we separate them into two groupings, macro and style factors.

Macro factors capture broad, systematic risks that explain returns across asset classes. These are economy-wide sources of risk such as growth, interest rates and inflation, and investors that target them may be able to earn long-run risk premiums in exchange for potentially bearing losses when economic conditions turn sour.

Style factors—our focus here—are the broad, predictable patterns of returns that explain the outperformance of certain securities relative to the overall market. Along with momentum and value, they include carry and defensive. Style factors explain risks and returns within asset classes, including equities, fixed income, commodities and currencies. Style factor investors can thus seek to earn returns, or reduce risks, by tilting portfolios toward these factors, both within and across asset classes.

Both macro and style factors are grounded in intuitive, fundamental ideas and have historically delivered a return premium by targeting one or more of the phenomena in the chart below.

A Matter of StyleThe long and the short of style factor investing

Rewarded risks

Investors may be able to earn higher long-term returns in exchange for bearing greater risks.

Structural impediments

Market rules or restrictions have made some investments off limits to certain investors, creating opportunities for others.

Behavioral biases

Not all investors have been perfectly rational all the time, generating opportunities for those who take a contrarian view.

1 The Economist Intelligence Unit’s January 2016 global survey of 200 executives from institutional investment firms. More information can be obtained at https://www.blackrock.com/institutions/en-us/insights/investment-actions/the-rise-of-factor-investing.

FACTOR PHENOMENA

The opportunities driving factor investing

Source: BlackRock, September 2016. For illustrative purposes only.

[ 4 ] A M A T T E R O F S T Y L E

The chart above maps these potential sources of return against the set of style factors that can be employed in a long/short, multiasset strategy.

For example, the long-run returns to the carry factor tend to be driven by a rewarded risk premium: higher-yielding assets have a higher implicit risk than lower-yielding assets. Returns to carry are also driven by structural impediments in bond markets that tend to force investors with long-dated liabilities, such as pensions and insurers, into longer-dated bonds, pushing prices up and yields down in this portion of the curve.

With momentum strategies, investors earn a premium for bearing the risk that such strategies can sell off, sometimes dramatically, when market trends suddenly reverse. Momentum may also result from a behavioral bias that can exacerbate trends: Investors tend to overreact to their own success, and this overconfidence tends to compound over time, leading to the continuation of trends.

While factor-based strategies have garnered increasing attention and acceptance in recent years, the theories behind factor investing are not new. Although many cite the development of the Capital Asset Pricing Model in the 1960s as the beginning of the modern factor movement, the case for style factors can be traced back to at least the 1930s and the pioneering work of Benjamin Graham and David Dodd that laid the intellectual groundwork for value investing.

More recently, market practitioners and academics have gone on to identify hundreds of factors that appear to provide the potential for outperformance relative to a market-cap-weighted portfolio. Indeed, anyone with a Bloomberg terminal or an Excel spreadsheet can create a compelling backtest. Unfortunately, very few of these strategies are likely to generate long-lasting returns in the real world.

But with many equity markets now at or near all-time highs and interest rates looking set to stay low for even longer, investors’ need for alternative, diversifying sources of return only seems to grow more acute. At the same time, volatility shocks—whether from unanticipated central bank moves or the U.K.’s surprise decision to leave the EU—have provided frequent and stark reminders of the need for diversification and downside risk mitigation.

In this challenging climate, we believe it makes sense to consider the fullest expression of style investing. By targeting exposures across multiple factors in multiple markets, investors can potentially achieve greater breadth and diversification. And by adding the ability to short, they can take on more precise exposures, which seek to minimize unwanted risks and provide a differentiated source of return compared to traditional asset classes.

In the pages ahead we’ll explore the broad case for investing in style factors and lay out some practical implications to consider in pursuit of building a long/short style factor portfolio that we believe can help investors meet their long-term risk and return objectives.

Source: BlackRock, September 2016. For illustrative purposes only.

WHAT DRIVES FACTOR RETURNS?Style factors and sources of potential returns

Defensive Value Momentum Carry

Rewarded risk ✔ ✔ ✔

Structural impediment ✔ ✔

Behavioral bias ✔ ✔ ✔

T H E L O N G A N D T H E S H O R T O F S T Y L E F A C T O R I N V E S T I N G [ 5 ]

Our approach to style investing is focused on those factors that possess the following criteria.

} Economic rationale – There must be strong economic intuition that explains why a factor premium should continue to exist, even after it is widely known and understood.

} Value creation – There must be empirical evidence of a factor generating positive returns over long periods of time.

} Diversification – A factor must demonstrate low correlations with other factors.

} Efficient implementation – Investors must be able to capture and implement a factor in a scalable, transparent, repeatable and cost-effective manner.

These are the tests we use to winnow the vast set of potential style factors down to the four intuitive investment styles that we believe can deliver long-term returns and diversification across multiple asset classes, as seen in the graphic to the right.

While many investors have focused on harnessing these factors in equity markets, there is a large body of academic literature that supports the long-run premiums for each of these factors across multiple asset classes.2 Investors that pursue style factor strategies in multiple markets can thus seek long-term returns across a wide range of assets, from mortgage bonds to emerging market stocks to global credit.

The case for style investing

FACTORS IN FOCUS

Source: BlackRock, September 2016.

Factors that have demonstrated long-term returns across asset classes

Value strategies target securities that are inexpensive relative to fundamentals.

Carry strategies favor high-yielding securities over low-yielding ones.

Momentum strategies capture recent trends by investing in securities with improving prices, fundamentals or market sentiment.

Defensive strategies, which include quality and low volatility, favor stocks with high-quality earnings or lower volatility.

2 Published research showing the historical outperformance of these factors includes: • Value: J. Lakonishok, A. Shleifer and R. Vishny, “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance, 1994. • Momentum: N. Jegadeesh and S. Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 1993. • Quality: R. Sloan, “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings.” Accounting Review, 1996. • Low volatility: A. Ang, R. Hodrick, Y. Xing, and X. Zhang, “The Cross-Section of Volatility and Expected Returns.” Journal of Finance, 2006.• Carry: R. Meese and K. Rogoff, “Empirical Exchange Rate Models of the Seventies.” Journal of International Economics, 1983.

[ 6 ] A M A T T E R O F S T Y L E

For example, the exhibits below illustrate the historical persistence of momentum in several asset classes over many decades. Momentum is based upon the idea that what performed well yesterday will continue to perform well

tomorrow, and, over the long run, high-momentum securities have outperformed low-momentum securities, across many asset classes and market cycles.

MOMENTUM EVERYWHEREHypothetical performance of the momentum factor across asset classes

Sources: Global Financial Data (GFD), BlackRock, May 2016. For momentum in FX: country currencies include Australia, Austria, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Norway, Singapore, Spain, Sweden, Switzerland, UK, Finland, New Zealand, and Portugal, all versus the U.S. dollar. For countries that joined the EU’s common currency in 1999, their respective currencies in the chart were replaced by the euro starting in January 1999. Recent Winners and Recent Losers are established by taking equally weighted portfolios of the currencies’ total returns over the prior 12 months (excluding the most recent month) and ranking each respectively. Total returns include spot returns and 3-month T-bill return differentials between the currencies. For momentum in equity indices: countries include Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Italy, Japan, Netherlands, Norway, Singapore, Spain, Sweden, Switzerland, UK, U.S., Finland, New Zealand, Ireland, and Portugal. MSCI country indices are used after January 1970, and GFD total return indices are used prior to January 1970. Recent Winners and Recent Losers are established by taking equally weighted portfolios of the indices’ total returns over the prior 12 months (excluding the most recent month) and ranking each respectively. For momentum in government bonds: countries include Australia, Austria, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Norway, Spain, Sweden, Switzerland, UK, U.S., Finland, New Zealand, and Portugal. Returns are GFD 10 year bond total return indices. Recent Winners and Recent Losers are established by taking equally weighted portfolios of the indices’ total returns over the prior 12 months (excluding the most recent month) and ranking each respectively. For momentum in commodities: commodities include soybean, soybean meal, soybean oil, wheat, corn, cocoa, coffee, cotton, sugar, gas oil, Brent crude, heating oil, natural gas, WTI crude, gasoline, aluminum, copper, nickel, zinc, gold, and silver. Recent Winners and Recent Losers are established by taking equally weighted portfolios of the commodities’ total returns over the prior 12 months (excluding the most recent month) and ranking each respectively. These equal-weighted portfolios are rebalanced monthly. All graphs are log cumulative unfunded returns. The performance shown is hypothetical, does not represent any existing portfolio, and as such, is not an investible product. Please see the notes at the end of this paper regarding the limitations of hypothetical performance.

Momentum factor in FX

Momentum factor in country equity indices Momentum factor in commodities

CU

MU

LATI

VE R

ETU

RN

Momentum factor in government bonds

-30

0

30

120

90

60

150%

-60

1955 1965 1975 1985 1995 2005 2015C

UM

ULA

TIVE

RE

TUR

N

-50

-75

-25

25

0

50

100

75

125%

-100

1975 1980 1985 1990 1995 2000 2005 2010 2015

CU

MU

LATI

VE R

ETU

RN

0

100

200

400

500

600

300

700%

-100

1955 1965 1975 1985 1995 2005 2015

CU

MU

LATI

VE R

ETU

RN

-50

0

50

150

200

250

100

300%

-100

1985 1990 1995 2000 2005 2010 2015

Recent losersRecent winners

T H E L O N G A N D T H E S H O R T O F S T Y L E F A C T O R I N V E S T I N G [ 7 ]

GOING LONG/SHORTMomentum and other long-only single-factor and multifactor strategies often follow a published benchmark and are now widely available via exchange traded funds and mutual funds. Such strategies can provide investors with a novel and efficient way to seek incremental returns within asset classes, particularly equities. However, the total returns for this type of strategy, like any long-only strategy, retain a significant amount of broad market exposure, while tilting toward the desired style factor or factors. For example, over the three-year period ending July 31, 2016, the MSCI USA Momentum Index had a beta of 0.92 and an R-squared of 82% relative to its parent index, the MSCI USA Index, according to our analysis of MSCI data.

Investors that can implement a long/short approach can better isolate style factors and disaggregate their behavior from broad market movements. For instance, an equity portfolio that has equal dollar exposure to high-momentum names on the long side and low-momentum names on the short side will have little net exposure to equity market beta. By further refining such a portfolio’s positions through the use of optimization techniques and risk models, we can also seek to eliminate net exposure to sectors, countries and other unrewarded risks.

In this way it is possible to construct a long/short equity momentum factor that has a beta close to zero and an R-squared of only 6% relative to the MSCI USA Index, our analysis shows. With market exposures neutralized, portfolio risk and returns are now driven predominantly by the spread between high-momentum and low-momentum securities. Harvesting style factors using both long and short positions seeks to isolate the style factors themselves rather than confounding them with broad market exposure.

Combining multiple factors together, especially across asset classes, can help further diversify risks, potentially resulting

A DIVERSIFYING ADDITION Hypothetical correlations among long/short multiasset style factors and major asset classes

Sources: BlackRock, Thomson Reuters. Correlations use monthly returns over the ten-year period ending July 31, 2016. The performance shown is hypothetical, does not represent any existing portfolio, and as such, is not an investible product. Please see the notes at the end of this paper regarding the limitations of hypothetical performance. Developed Equities: MSCI World Total Return Index USD, Global Bonds: Barclays Global Aggregate USD Hedged Index, Commodities: Bloomberg Commodity Index TR USD, US Dollar Index: US Dollar Index DXY.

in a portfolio with a high Sharpe ratio and low total risk expectations. But such a portfolio will also have low expected returns. In order to compensate for the low return expectations, investors may need to embrace the use of leverage. By applying prudent amounts of leverage to the overall portfolio, it is possible to boost returns into a more attractive range while retaining the highest possible Sharpe ratio.

Because many institutional investors are prohibited from using leverage, those investors that are willing to bear the risks that come with employing a levered strategy may be able to take advantage of this structural impediment on those that cannot. Indeed, widespread aversion to leverage may partially explain why low-volatility securities have displayed higher risk-adjusted returns than their high-volatility peers. For example, the MSCI USA Minimum Volatility Index has displayed higher Sharpe ratios than its parent index, the MSCI USA Index, over the one-, five- and ten-year periods ending August 31, 2016.

A DIVERSIFYING APPROACHEmploying a long/short approach across asset classes can create a powerful source of diversification in investors’ portfolios. Individual style factors have tended to display low correlations with each other, and with traditional asset classes. In the chart below, the upper-left quadrant illustrates the correlations among long/short multiasset factors. Combining style factors with near-zero pairwise correlations can help to construct a well-diversified, high-Sharpe-ratio portfolio.

The upper right quadrant illustrates the near-zero correlations of style factors with several traditional market indices. It is this low correlation with traditional asset classes—and with the core holdings of investors’ portfolios—that is perhaps the most compelling feature of style investing.

Value Momentum Carry Defensive Developed Equities Global Bonds Commodities U.S. Dollar Index

Value 1.0 -0.3 0.1 0.2 0.0 0.0 -0.2 0.0

Momentum 1.0 0.0 -0.1 -0.2 0.1 0.1 0.1

Carry 1.0 -0.2 0.4 0.1 0.3 -0.2

Defensive 1.0 -0.2 -0.1 -0.4 0.2

Developed Equities 1.0 0.0 0.6 -0.6

Global Bonds 1.0 -0.1 -0.1

Commodities 1.0 -0.7

U.S. Dollar Index 1.0

[ 8 ] A M A T T E R O F S T Y L E

While the motivations for style factor investing seem clear, building a robust and effective strategy requires a nuanced understanding of the factors themselves, of quantitative portfolio management and of capital market structure. Over nearly three decades of developing, refining and implementing factor-based strategies, we have learned a few critical lessons about how to put style factors to work in investment portfolios:

} Emphasize economic intuition (and beware of data mining)

} Build exposures carefully and target the desired risks

} Manage implementation effectively

AN ECONOMICALLY GROUNDED APPROACH

Style investing is based upon intuitive concepts, such as value. While the notion of value is straightforward, there are innumerable ways to measure it. Indeed, a critical aspect of style investing is selecting and tuning the metrics to measure a security’s attractiveness with regard to specific factors.

Measuring style exposures requires a careful balance of simplicity and nuance. We seek to capture intuitive ideas without unnecessary complication or data mining. For example, we have seen investors define value in equities in some exceedingly complex ways. In the 1990s, we saw multiple-period dividend discount models that included information on interest rates, long-term earnings forecasts and GDP growth. In the 2000s, we saw value defined in terms of complex residual income models to address concerns related to the diversity of international accounting standards.

Our experience with such models suggests that simplicity often wins out over complexity. For value investing, we utilize traditional, time-tested metrics, and we find that combining multiple metrics is additive. Our value model includes measures of earnings and cash flow, using historical and forward estimates, compared to price and enterprise value. And while we favor simplicity where possible, we seek to uncover those exceptions that merit special treatment. For example, book value or cash flow metrics are not particularly germane in the evaluation of financial stocks.

Once we select the appropriate metrics, we must convert this raw data into portfolio holdings, with many important choices to be made. Should positions be neutralized to sectors and regions? Should we smooth estimates to emphasize more recent events, and at what half-life? Should we adjust the data for volatility? How should we combine and weight multiple measures of a single factor?

All these choices have a significant impact on the complexion of the resulting portfolio, and must be evaluated with care. However, if one tortures the data long enough, it is always possible to find an attractive-looking backtest. But backtests reflect what’s worked well in the past and are heavily influenced by events that occur over the sample period. A healthy dose of skepticism must be applied to the data contained in any backtest. We don’t trade on data that’s not backed by a strong economic intuition, and our research process contains sense checks to help ensure that data have not been overengineered.

Our philosophy here can be summed up by the following: There must be a compelling economic rationale for the long- and short-run behavior of each style factor that we will attempt to harness, and good economic thinking outweighs backtested returns. Our research is focused on broad, persistent sources of return: phenomena that are observed over decades, or even centuries. Recent data provides us with perspective on today’s market environment and is always important, but should be tempered by both intuition and a longer-term perspective.

Putting style factors to work: lessons learned in style investing

T H E L O N G A N D T H E S H O R T O F S T Y L E F A C T O R I N V E S T I N G [ 9 ][ 8 ] A M A T T E R O F S T Y L E

For example, consider currency carry strategies. Currency carry has been largely out of favor since the global financial crisis. As seen in the bottom half of the chart below, if investors focus only on the last 10 years of data, this strategy does not look particularly compelling—performance has been approximately flat since the large drawdown of carry in 2008.

But the longer term paints a different picture: Currency carry has been a consistent source of long-run return, with occasional periods of drought. Examining today’s market environment, our research suggests that central bank intervention and ultralow interest rates may be distorting the behavior of currency markets. This leads us to believe that currency carry is not extinct, but perhaps muted for the time being. Our response would be to consider down weighting, but not eliminating, exposure to carry.

As the carry example demonstrates, individual style factors are inherently cyclical and may suffer periods of underperformance. In order to counteract short-term underperformance in any one factor, it is essential to build portfolios with breadth. Breadth is the number of times we can exploit an investment idea, and more is better. Investing in a diverse set of securities, in many markets, across many factors prevents any one asset or factor from dominating returns.

For example, over the last 10 years, momentum within individual asset classes has suffered from some large drawdowns. But the average pairwise correlation for long/short momentum strategies across different asset classes is only 0.16, according to our analysis of the data sources in the chart above. The chart illustrates the performance of a long/short momentum strategy in different asset classes across three extreme market scenarios. In each period, at least one strategy generated positive returns to help offset the drawdowns in other strategies, creating a source of diversification in difficult times.

BUILD CAREFULLY AND MIND THE RISKS Although the concepts that underlie factor investing and the metrics that underlie the factors themselves may be straightforward, that does not mean that the resulting investment strategies should be simple. They shouldn’t—they need to be intelligently and efficiently constructed, and they must target the intended set of risks.

KEEP CALM AND CARRY ONHypothetical performance of currency carry, 1974-2016

BENEFITS OF BREADTHHypothetical performance of the momentum factor during turbulent markets

Source: Global Financial Data, September 2016. For illustrative purposes only to demonstrate how a carry trading strategy may produce different outcomes within short term and long term periods. The “Top Minus Bottom Carry” line represents an equal-weighted portfolio long the top-performing currencies, sorted by their 3-month T-bill differential versus the U.S. dollar, and short an equal-weighted portfolio of the lowest-performing currencies, sorted by their 3-month T-bill differential versus the U.S. dollar. Currency countries include Australia, Austria, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Norway, Singapore, Spain, Sweden, Switzerland, UK, Finland, New Zealand, and Portugal, all versus the U.S. dollar. The performance shown is hypothetical, does not represent any existing portfolio, and as such, is not an investible product. Please see the notes at the end of this paper regarding the limitations of hypothetical performance.

Source: BlackRock, September 2016. The performance shown is hypothetical, does not represent any existing portfolio, and as such, is not an investible product. Please see the notes at the end of this paper regarding the limitations of hypothetical performance. Returns are in excess of one-month T-Bills, adjusted to ex-ante risk level of 5%, and gross of all fees and transaction costs. U.S. Downgrade: July 21-September 20, 2011. Taper Tantrum: May 21-June 24, 2013. Chinese Concerns: June 12-August 26, 2015.

0

100755025

125%

CUM

ULA

TIVE

RET

UR

N 40 YEARS

10 YEARS

-25

Top minus bottom carry

1975 1980 19901985 1995 2000 2005 2010 2015

CUM

ULA

TIVE

RET

UR

N

0

15

10

5

-5

20%

-10

2005 2007 20112009 2013 2015

4

2

0

-2

-4U.S. Downgrade

2011

RET

UR

N O

VER

PER

IOD

Taper Tantrum2013

Chinese Concerns2015

6

8%

Fixed income momentumCommodity momentumEquity momentumFX momentum

[1 0 ] A M A T T E R O F S T Y L E

As the currency carry example highlights, one of the keys to turning the relatively simple concepts behind factor investing into sufficiently robust strategies is to manage risks effectively. Naively constructed portfolios can contain many unwanted and uncompensated risks—exposures that add volatility, but not expected returns.

For example, value strategies often have persistent overweights to financial stocks and underweights to technology stocks. As style investors, our intent is to focus on the spread between cheap and expensive stocks, not to consistently overweight one sector or country versus another. Neutralizing style metrics by sector or region gives portfolios the opportunity to capture style premiums within those segments—a neutralized value strategy might be long one automaker and short another, with no net position in U.S. equities or consumer discretionary stocks.

Such a strategy would be insulated from broad equity-market moves as well as market rotation across sectors. In this case, a deterioration in consumer sentiment could trigger a selloff in consumer discretionary stocks as a whole, but have little impact on the relative valuation of the two automakers. Neutralization means the portfolio is focused on the risks we want, namely the spread between cheap and expensive securities, while eliminating the noise from unintended bets.

IMPLEMENTATION MATTERSIn addition to constructing factor strategies intelligently and targeting the appropriate set of risks, investors must implement those strategies effectively if they hope to take full advantage of the returns that style factors may offer.

Many strategies test well on paper but fail in real-world markets. Without skilled implementation, transaction costs can quickly erode returns. Commissions, bid-ask spreads, taxes and market impact can create meaningful headwinds, if not carefully managed. The optimal portfolio after considering transaction costs may be meaningfully different from a paper portfolio that ignores such costs, so transaction cost forecasts should be explicitly included in portfolio optimizations.

To illustrate this important concept, the chart on the following page demonstrates the hypothetical return of a long/short minimum-volatility portfolio, with and without optimizing for transaction costs (t-costs) prior to trading. The top line represents the estimated total returns of the strategy on paper, without accounting for transaction costs. The bottom line represents the hypothetical post-cost return of the strategy that is constructed and traded without any knowledge of potential transaction costs. The impact of t-costs is enormous, resulting in a 43% drag on performance versus the portfolio that does not take into account transaction costs.

CARRIED AWAYPerformance of G10 currency carry strategies

Sources: BlackRock, Bloomberg, June 2016. For illustrative purposes only to demonstrate how different implementations of a G-10 carry strategy can produce disparate results. These strategies were chosen from Bloomberg due to their being described as simple carry strategies. Not representative of any BlackRock portfolio or strategy.

The importance of portfolio construction can be seen in the chart above, which plots the historical returns of eight published G10 carry strategies. On the surface, it is hard to think of a more straightforward strategy than one attempting to harvest carry from the G10 group of currencies. The strategy is simple: go long the highest-yielding currencies and short the lowest-yielding ones. There are only 10 assets in the universe, and just one variable: the yield on the currencies. Yet the real-world results of such strategies display extremely wide dispersion.

While all of the strategies involve buying currencies with the highest short-term interest rates and selling those with the lowest, there are many ways to implement such a strategy. A simple approach would be to split the universe in half and buy the highest-yielding currencies in equal proportions, while selling the lowest-yielding currencies in equal proportions.

However, this construction leaves out two important considerations: the magnitude of interest rate differentials across countries and the risk profile of the currencies. A more robust approach would size positions to maximize the expected return for a given level of risk, in order to better capture differences in the magnitude of the premium, while controlling for the risk associated with the exposure. These nuances in portfolio construction can result in dramatically different exposures—and returns.

CU

MU

LATI

VE R

ETU

RN

0

120

80

40

160%

-40

Strategy 2Strategy 1 Strategy 4Strategy 3

Strategy 6Strategy 5 Strategy 8Strategy 7

2001 2003 2005 2007 2009 2011 2013 2015

T H E L O N G A N D T H E S H O R T O F S T Y L E F A C T O R I N V E S T I N G [11]

MIND THE COSTSHypothetical performance of minimum volatility strategies, with and without modelling transaction costs

Source: BlackRock, August 2015. The Min Vol portfolio is BlackRock’s global equity minimum volatility factor, which uses a stock’s specific risk as the signal insight for over 2800 single name stocks in 21 countries. Naive Pre-TC uses the returns produced by the Min Vol factor and does not incorporate transaction costs. Naive Post-TC incorporates transaction costs but is not optimized to current market liquidity and conditions. Optimized Post-TC incorporates transaction costs and is optimized to current market liquidity and conditions, as per BlackRock’s portfolio management system, Portfolio Insights. For illustrative purposes only to demonstrate how optimizing a portfolio for transaction costs can potentially provide cost savings. The performance shown is hypothetical, does not represent any existing portfolio, and as such, is not an investible product. Please see the notes at the end of this paper regarding the limitations of hypothetical performance.

While transaction costs are unavoidable, they can be reduced by explicitly incorporating t-cost analysis into the portfolio optimization process. In this example, the careful management of costs lowered their impact on performance by 40%, as seen in the middle line of the chart above.

Perhaps the most effective way to control transaction costs is to minimize turnover within the strategy. And one of the best ways to minimize turnover is to manage factor exposures holistically, within a single, multiasset portfolio, rather than a collection of individually constructed factor strategies.

By pursuing a single-strategy, multiasset approach, investors are able to net any offsetting positions that may arise as a result of overlapping positions across different factors. For instance, a momentum factor may dictate a long position in a certain security with strong recent performance, while a value factor may call for a short position in that same security. By netting out these offsetting positions within a multifactor strategy, investors may substantially reduce turnover, and thus trading costs.

Netting positions can also significantly reduce capital and leverage requirements, which can help investors allocate their capital and risk budgets more efficiently. See the chart on the right.

FINDING A FIT FOR FACTORSThe benefits of netting make a compelling argument for a well-constructed multiasset, multifactor strategy, rather than a collection of single-factor strategies.

Where such a strategy can fit in an institutional portfolio depends on the goals and the structure of the specific investor. Many investors are placing the strategies within an absolute return portfolio, oftentimes alongside their hedge fund allocations. We believe this is a logical choice, as style factors can be complementary to hedge funds that are delivering true alpha. Alternatively, a style portfolio can serve as a lower-cost replacement for hedge funds that are not delivering true alpha, but are harnessing predominantly market or factor exposures instead.

Other investors, particularly public funds, are starting to incorporate style-factor investing into risk-mitigation strategies that attempt to provide explicit diversification from equity risk, as well as downside risk mitigation during volatile markets. These investment goals are similar to those of overlay programs, which are widely used by a variety of investors as a means to add uncorrelated returns to their portfolios.

Finally, a small portion of investors now view their entire asset allocation and portfolio construction processes through a factor lens. For these investors, factor investing, rather than asset class investing, is the primary means for allocating capital, with both macro and style factors acting as the building blocks for the overall portfolio.

Whichever view they take, we believe that style factors will play an increasingly important role in institutional portfolios in the years ahead, and that investors will come to view the holistic, multiasset approach to style investing as a valuable tool for pursuing diversifying sources of return in a low-return and higher-volatility climate.

CU

MU

LATI

VE R

ETU

RN

0

60

50

40

30

20

10

70%

-10

Naive post-TCNaive pre-TC Optimized post-TC

1997 1999 20032001 2005 2007 2009 2011 2013 2015

NET GAINSHypothetical netting, turnover and leverage, in multiasset, multifactor portfolios

Source: BlackRock, September 2016. The chart shows how portfolio turnover per unit risk and gross leverage per unit risk can be reduced when common positions are netted across factors, versus trading each individually, in a hypothetical multiasset, multifactor portfolio. This spans twelve different proprietary BlackRock style factors and nets the common positions across them. The performance shown is hypothetical, does not represent any existing portfolio, and as such, is not an investible product. Please see the notes at the end of this paper regarding the limitations of hypothetical performance.

Without netting With netting

Normalized turnoverper unit risk

Normalized gross leverageper unit risk

1

2

3

4

5x

0

Reducedby 30%

Reducedby 21%

This material is provided for educational purposes only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2016 and are subject to change. References to specific securities, asset classes and financial markets are for illustrative purposes only and are no intended to be and should not be interpreted as recommendations. Indices do not include fees or operating expense and you are not able to invest directly in an index.

This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, any historical performance information of other investment vehicles or composite accounts managed by BlackRock, Inc. and/or its subsidiaries (together, “BlackRock”) included in this material is presented by way of example only. No representation is made that any performance presented will be achieved by any BlackRock Funds, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example. Past performance is no guarantee of future results.

The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy.

There are frequently sharp differences between a hypothetical performance record and the actual record subsequently achieved. Therefore, hypothetical performance records invariably show positive rates of return. Another inherent limitation of these results is that the allocation decisions reflected in the performance record were not made under actual market conditions and, therefore, cannot completely account for the impact of financial risk in actual portfolio management.

Index returns are for illustrative purposes only and do not represent any actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Data for time periods prior to the index inception date is hypothetical and is provided for informational purposes only to indicate historical performance had the index been available over the relevant time period. Hypothetical data results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance, and cannot account for risk factors that may affect the actual fund performance. The actual performance of the strategy or fund may vary significantly from the hypothetical index performance due to transaction costs, liquidity or other market factors. Index methodology available upon request. It is not possible to invest directly in an index.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass.

These materials are neither an offer to sell nor a solicitation of any offer to buy shares in any fund. You may not rely upon these materials in evaluating the merits of investing in any fund that employs any of the strategies referred to herein. Any reference herein to any security and/or a particular issuer shall not constitute a recommendation to buy or sell, offer to buy, offer to sell, or a solicitation of an offer to buy or sell any such securities issued by such issuer.

For recipients in the EU: In the EU issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Conduct Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. In Canada, this material is intended only for institutional investors that qualify as both an “accredited investor” and a “permitted client” as defined by Canadian securities laws. This material is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. For recipients in Latin America: In Latin America, for institutional investors and financial intermediaries only. This material is for educational purposes only and does not constitute an offer or solicitation to sell or a solicitation of an offer to buy any shares of any fund or security and it is your responsibility to inform yourself of, and to observe, all applicable laws and regulations of your relevant jurisdiction. If any funds are mentioned or inferred in this material, such funds have not been registered with the securities regulators of Brazil, Chile, Colombia, Mexico, Panama, Peru, Uruguay or any other securities regulator in any Latin American country and thus, may not be publicly offered in any such countries, except for Chile where certain funds have been registered with the Superintendencia de Valores y Seguros for public offering and in Mexico where certain funds have been listed on the international quotation system (Sistema Internacional de Cotizaciones, SIC) of the Mexican Stock Exchange (Bolsa Mexicana de Valores, S.A.B. de C.V.). The securities regulators of any country within Latin America have not confirmed the accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America. The contents of this material are strictly confidential and must not be passed to any third party.

FOR INSTITUTIONAL, FINANCIAL PROFESSIONAL, AND PERMITTED CLIENTS USE ONLY. THIS MATERIAL IS NOT TO BE REPRODUCED OR DISTRIBUTED TO PERSONS OTHER THAN THE RECIPIENT.

©2016 BlackRock, Inc. All rights reserved.

Lit. No. INST-STYLE-0916US 169123T-INST/UIM-0463

WHY BLACKROCK®

BlackRock helps people around the world, as well as the world’s largest institutions and governments, pursue their investing goals. We offer:

} A comprehensive set of innovative solutions, including mutual funds, separately managed accounts, alternatives and iShares® ETFs

} Global market and investment insights

} Sophisticated risk and portfolio analytics

We work only for our clients, who have entrusted us with managing $4.89 trillion, earning BlackRock the distinction of being trusted to manage more money than any other investment firm in the world.*

* Source: BlackRock. Based on $4.89 trillion in AUM as of 6/30/16.

Want to know more? blackrock.com

Not FDIC Insured • May Lose Value • No Bank Guarantee