‘Factor investing will unleash a revolution’
A revolution in investment management is about to happen due to factor investing, says Professor Andrew Ang. Factor benchmarks to assess investment managers will contribute hugely to this change.
Understanding the nature of risk and return in asset prices is at the heart of Professor Andrew Ang’s research. The professor of Columbia Business School was keynote speaker on the Robeco Factor Investing Seminar. After his lecture for approximately 100 professional investors we took the opportunity to speak with him separately.
How would you define factor investing?
Factor investing is an investment style that aims to make money over the long term. It involves harvesting a long-run risk premium. Factor investing involves risk, so sometimes there are short-term losses.
Some of the factors involved are very simple factors and well known such as equities and bonds. These are the extra returns you get when investing in these markets. And some are more sophisticated dynamic factors such as value, growth, momentum, volatility, credit and duration.
Factor investing is a way of making strategic choices - what drives returns? But it can also be a source of diversification or alpha compared to traditional market-weighted benchmarks.
Just like ‘eating right’ requires you to look through food labels to understand the nutrient content, ‘investing right’ means looking through asset class labels for the underlying factor risks. It's the nutrients in the food that matter. And similarly, the factors matter, not the asset labels.
To take the food analogy further, the advice you would give for a baby with regard to nutrients is not the same as the advice you would give to an adult. There is no optimal mix for allocating factors either - it all depends on investor preference.
You spoke of factor investing in terms of a revolution, but this is a slow process. Isn’t this more an evolution?
Actually, it has already unleashed two revolutions. The first revolution in investment management on harvesting factors occurred when the first market-index funds started in the 1970’s. The first revolution was very slow. Now a second revolution in dynamic factors is about to take place.
The second revolution is complicated, but the first one to create market-index funds was also complex. Just take the constantly changing price of the underlying securities. It may seem easy now, but the people who started these funds did not think so.
And the second one will also take time. This has to do with how people think and how the industry is structured. It is hard to get people to change.
What is the biggest challenge for factor investing?
The biggest challenge lies in the mindset of the investor. Organizational issues are also significant. Where does factor investing belong in an organization? We need to have structures in place to make sure we can stay the course, as factors are not always going to work. Sometimes they will fail, and sometimes skittish investors will get out right at the wrong time. Factor investing takes commitment and knowledge.
Portfolio management is not the biggest challenge. Clearly, there are more ways than one to manage a factor portfolio, but wanting to manage one is what counts most. There are already asset managers who can deliver on factor investing.
‘Factors are not always going to work’
How do you see factor investing in the debate on active versus passive management?
The debate is wrong. Everything is active - even just choosing the proportion of equities in your portfolio, or how often to rebalance it. These are active decisions.
What about the discussion of investment-management fees?
You should never overpay for something you can get more cheaply. The discussion about costs is linked to the use of factor benchmarks to assess investment managers. We need transparency on the underlying factors that drive performance. How much of a manager’s performance is alpha and how much is factor exposure?
Unfortunately, investors do not evaluate enough. Take the case of hedge funds - they do not evaluate performance against a factor benchmark. But they should! Why pay 2/20 [2% management fee, 20% performance fee] when you can get it for free? If you evaluate, you pay only where this is warranted.
Besides performance evaluation, factor benchmarks can be used for strategic allocation choices. Choosing between factor benchmarks - which differ just like long-only equity benchmarks - is an active decision.
Factor benchmarks can also be used to keep your active portfolio manager from deviating too much. For you, as an investor, these benchmarks represent optimal exposure to risk premiums.
‘We need transparency on the underlying factors’
Will factor investing become mainstream?
Like market-index funds, this will become a mainstream trend. This is not in evidence yet, however, and even when the trend sets in, only a minority of investors will be willing to follow it at first.
The capital asset-pricing model started being applied in the 1950’s and 1960’s. It only became mainstream for investors in the 1990’s and into the 21st century (i.e. 30 - 40 years). The first academic factor papers appeared in the late 1970’s. Much empirical research took place in the 1980’s and 1990’s. We are only 20 years further now. Some developments take a long time.
What part of factor investing needs more research?
The real research challenge lies in illiquid markets like private equity, infrastructure and real estate. How do you separate and measure their factor exposures? How do you measure returns? Can we make this area less opaque? Those are the big questions we should ask ourselves.
Some of my recent papers are focusing on this subject. It would be of tremendous benefit for investors if we could bring public benchmarks to those markets. But we don’t have them yet.
The report you helped to write for Norway on its sovereign wealth fund put factor investing on the agenda of professional investors in the Netherlands. Did you expect that?
No, it was an assignment for the government. I am glad to hear it made an impact. Norway was very transparent about our report on the value of active management. The country has provided a great service to the investment community.