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Investing in market-cap weighted indexes and factor indexes has serious disadvantages, according to Han Dieperink and Joop Huij. An active approach to factor investing works better.
“A slow-growth world is also a low-return world. So how can investors still get decent returns?” This was the key question that Han Dieperink, CIO of Rabobank Retail & Private Banking, asked the audience of wholesale and institutional investors at the Robeco World Investment Forum in Hong Kong.
Dieperink implemented factor investing into his clients’ equity portfolios this year. Together with Robeco’s Head of Factor Investing Research, Joop Huij, he discussed how it can best be implemented, and just as importantly, what should be avoided.
The challenges of index investing
“Private clients face the challenge of getting decent future returns from their bond and equity portfolios. And index investing is one way to gain exposure to the equity market,” says Dieperink. “One advantage of these index-based products, such as ETFs, is their low costs, but there are also challenges. ETFs have been known to cause flash crashes, and then there is the issue of illiquidity.”
”Another disadvantage of the market-cap weighted index products is that they do not always reflect the exposure you want to have in sectors and regions. Indexes can reflect boom and bust cycles. For example, at the end of the 1980s during the height of the Japanese property bubble, the weight of Japan in the MSCI World was more than 40%.”
“Passive investing guarantees that an investor will experience all of the losses along with the market index, when a bubble in a particular sector or country bursts. Another issue is that the world economic center of gravity is constantly changing, and an index does not always reflect these changes.”
‘Would you feel comfortable if you knew that your trades would be public?’
“So index investing has issues, and that was one of the reasons why we decided to also allocate to factor investing,” says Dieperink. He sums up the others. “Factor investing enables us to optimize how we use our risk budget; its rules-based approach takes effective advantage of behavioral biases, and it offers a better risk-return portfolio.” He warns: “The factor premiums are attractive, but to fully reap the potential benefits, the strategy has to be implemented well.”
Generic factor investing indexes exposed to front-running and overcrowding
Factor investing can be implemented by using generic factor indexes. Although Joop Huij acknowledges the transparency of this approach, he points out serious disadvantages. “Like market-cap investing, there is plenty of information available on the index constituents, and on pending changes. This is an attractive feature, because it gives a lot of insight into performance. But this transparency also has serious disadvantages. It can lead to front-running by hedge funds before announced index changes can be applied to the portfolio. It can also lead to overcrowding because large numbers of market participants buy and sell at the same time.”
Huij continued his presentation by asking the audience two questions on their investment strategies: “Would you feel comfortable if you knew that the trades of your strategy would be public and that other market participants were able to exploit this knowledge by front running? Or with the idea that other asset owners were engaging in exactly the same trades on the same day?”
Front-running and overcrowding are serious concerns when rebalancing portfolios, but there had never been any research into this subject. At least not until Huij initiated a study with Georgi Kyosev in order to fill the gaps in the literature. “If you look at new inclusions, these stocks already start to increase in price five days before rebalancing,” says Huij.
“On the sell side the results show the opposite – prices go down prior to exclusion. These effects can be seen in the graph below: ‘i’ is when the index is rebalanced.”
Outperformance before and after factor index inclusions
Source: Huij and Kyosev, 2015, working paper. The results are calculated for MSCI World Minimum Volatility USD Index over the sample period (Sep 2010-Dec 2014). Returns are in USD. The graphs show cumulative outperformance of new buys/new sells over all constituents in the MSCI Minimum Volatility Index at the relevant point in time. Between i-1 and i is when the index is rebalanced and a stock is included in/excluded from the index. i-7 is 7 days before rebalancing, etc. The graphs show returns averaged over all rebalancing periods from Sep 2010-Dec 2014.
“It would require a completely new generation of factor investing investment vehicles that offer investors transparency without sharing sensitive information with the public,” says Huij.
It helps to select stocks in a different way
Moreover, the way in which Robeco selects stocks is different, which helps to avoid overcrowding. “It is possible to capture factor premiums more efficiently by setting up a high-conviction approach, says Huij. “If you implement factor strategies well, you can earn higher returns, reduce risk and cut trading costs. A good factor strategy avoids three pitfalls: unrewarded risk, negative exposure to other factor premiums and unnecessary trading costs.”
“Factor investing in itself is not the Holy Grail, because implementation is so important,” concludes Dieperink. “And front-running and overcrowding are key considerations for me.”
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