Factor investing and its implementation: ‘All roads lead to Rome’
Interest in factor investing - investing in systematic sources of return - is rapidly increasing. But how are pension funds incorporating factor investing into their portfolios and investment processes?We asked Alfred Slager, professor in Pension Fund Management at the TiasNimbas Business School at the University of Tilburg, the Netherlands. Alfred Slager wrote the research paper 'Factor Investing in Practice: A trustees' Guide to Implementation' together with Professors Kees Koedijk and Philip Stork. This paper concludes that factor investing can take several forms: “But eventually - all roads lead to Rome.”
What is the background to this second research paper?
Factor investing has been much talked about, but so far we have little information on how it can be implemented. A follow-up paper was therefore needed to assemble the knowledge and experience of funds that have already started using factor investing in order to help other funds find their own way of implementing this investment strategy.
When we started our first study, it soon became clear that we were dealing with two separate questions. The first of these focuses on how factor investing is developing. This is the theoretical angle, which we dealt with in our first paper. The second asks how exactly institutional investors apply factor investing, and this is the subject of our second paper.
What surprised you most in this paper?
That there are different ways of implementing factor investing. Little was known about the practical aspects before we started our study (e.g. about incorporating factor investing into your investment process - managing it - the role of the regulator).
Why is factor investing in the limelight now?
Two simultaneous signals triggered this interest. First, the big financial crisis of 2008/2009; diversification turned out to be more of a problem than expected, which caused this and other basic investment principles to become important items on everyone's agenda. How can we fix things to ensure we emerge stronger from the next financial shock?
Second, pension funds have become more critical about the role of active management. Pension funds, while willing to pay for the skills of a portfolio manager, are not prepared to do so to achieve factor-based returns that they could also generate in their portfolio by other means. Factor investing contributes to the discussion of the role of active management.
What is your own experience of the way pension funds look at factor investing?
There are funds that implement factor investing and feel that it contributes positively to their portfolio composition. They may use factor-based benchmarks, for instance. Other funds are still watching from the sidelines. They see factor investing as a kind of black box. But they, too, would like to strengthen their portfolio and diversify more effectively.
Why are Dutch and Scandinavian investors ahead of the pack in this area?
They have large amounts of institutional capital and a long-term investment horizon. But they also want to control the risks of negative shocks more effectively in the short term. In addition, Dutch and Scandinavian funds emphasize transparency, cost control and well thought-out investment processes. Finally, they focus strongly on investing scientifically.
Will all institutional investors apply factor investing in future?
We will see this increasingly in many different variants. Something for everybody. What all these investors have in common is their desire to combine stable and enhanced diversification with new opportunities for returns.
Which other professional investors will decide to use factor investing?
I wouldn't be surprised to see foundations, associations and private wealth funds applying factor investing. There is a barrier to this, however. We are turning away from our familiar equities and bonds. Term spread and liquidity premium are concepts that are more abstract, and also harder to explain. On the other hand, a factor portfolio can be seen to ensure more stable returns.
What different methods of implementing factor investing are there?
In our research paper we discuss different variants. Institutional investors often implement factor investing in stages.
They may initially decide to use the first variant, the so-called 'risk due-diligence' method. Without immediately adjusting the portfolio, they consider exposure to different factors. You can use asset allocation to increase or decrease your exposure. An analogy would be a health scan.
The second variant entails making a more conscious choice to use factors for strategic asset allocation. In this case, you adapt your investment style and benchmark to these factors. Factors that are not used in your traditional investments can be applied to alternatives.
The third variant is the most logical one. For this, you base your entire portfolio on factor premiums. However, there are only a few parties that currently do this.
What are the three biggest obstacles to implementation for institutional investors?
Firstly, the language of factor investing is an obstacle. It is less concrete, and the terms are less well known. Secondly, there is the implementation issue of re-balancing; incorporating this effectively into investment processes requires a major effort by investors. And a third obstacle is that these are new and complex investments for many managers. It’s not really in the spirit of our times to try out new and challenging things.
What are the main differences between these approaches?
The difference lies in how rigorously you wish to implement factor investing. You can apply different variants. But whatever option you choose, you will be fully aware of what is happening in your portfolio.
‘There are different options for implementing factor investing’
What do the regulators think about factor investing?
There are positive and negative aspects. A robust portfolio is a positive aspect. Increased transparency of costs is another. Factor investing gives pension funds a better idea of what they do and don't pay for.
There is also a clear negative aspect from the regulator's point of view. The notion of being in control produces potential conflicts between the regulator on the one hand and the manager or pension fund on the other. There is much to regulate. In operating terms, this raises the bar somewhat for those who wish to start factor investing. However, practical experience has already demonstrated that there are many feasible ways to implement this strategy. Professional investors will therefore increasingly be allocating to factors in future.