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What are the challenges of smart beta and factor investing? Factor strategies will have a profound impact on the way portfolios are constructed, says James Price, Investment Consultant at Towers Watson. “This impact will be felt throughout the entire investment process.”
Towers Watson advises institutional funds on a delegated basis. Price was one of the speakers at the Robeco Factor Investing Seminar in Rotterdam. We interviewed him after his presentation. “It may be difficult to observe correlated factor risks across the portfolio.”
Our view is that smart beta and factor strategies help asset owners to improve exposures in their portfolios to meet their goals. Smart Beta is a very broad concept with a wide impact. Part of this is ensuring operational efficiencies are realized, that the investment beliefs and strategies are in sync and that portfolios are reviewed on the basis of asset and factor allocations. It is also important that non-financial risks and sustainability factors are taken into account.
Improved exposures to meet their goals
The skillset required from a consultant to help the asset owner is evolving, because the type and structure of advice is changing. But this will not affect the broader work consultants do for asset owners such as risk assessment, strategic asset allocation, investment manager selection and delegated investment services.
When used appropriately, the application of factor strategies is definitely a positive. Considering factor exposures is a useful lens through which to view investors’ current portfolios and it helps to construct the portfolio they might wish to have.
Factor products within investor’s portfolios allow an asset owner to have factor exposure in a cost-effective way. In the past, investors may have paid high active fees for a product where performance was largely the result of exposure to one or more factors, something they were not aware of. Retaining that same exposure while reducing costs will benefit investors.
Useful lens through which to view portfolios
People will start to think more explicitly about the smart betas or factor exposures embedded in a portfolio, either through deliberate allocation, or as a result of their alpha-seeking active managers. The increased focus from consultants and asset owners on understanding exposures is definitely positive.
It helps to break down some of the boundaries that might have existed historically between different asset classes and opens up new ways to think about constructing portfolios. One might have a risk-premium starting point and allocate to factors and then select assets to implement those factors. So assets will no longer be the starting point for some asset owners.
It creates more options in terms of portfolio construction. That may give rise to new types of products which focus on delivering premiums across asset classes.
It depends on the beliefs and objectives of the asset owner, and how their organization is structured.
For some it will open up a totally different way of constructing a portfolio. It might lead to a need for more complicated strategies and their organizations will evolve. In other words: add the organisational capabilities to match with the investment process.
But for others, the primary drivers of the investment strategy will remain asset allocation, possibly because of their level of understanding or due to constraints by external parties. That might be a regulator or a third party that is providing them with a mandate to invest in certain asset classes. Any pursuit of a factor strategy will be within those constraints.
There are different challenges. One of them is making sure that the organizational capabilities match what is required to execute the investment strategy. As markets evolve some historic experiences of how parts of the portfolio will behave are no longer as relevant and that might be challenging for some existing organizational structures to manage.
For example, it may be difficult to observe correlated factor risks across the portfolio, if an organization is set up to focus on risk within different asset classes. If the future, organizations should be set up to observe and manage these risks.
Another challenge is the implementation. It is important to ensure that the right product is available and that there are appropriate implementation routes. For example, if you are a very large asset owner, you have the capability to implement customized accounts that meet your requirements.
Correlated factor risks across the portfolio
And if you are a small asset owner, you may choose to use these ready-made products to reduce the operational complexity, or you might be forced to do so because you lack the size for customized structures. In which case, a limited availability of pooled funds might restrict the ability to choose particular factors. But while large investors might be able to choose a customized solution, they face capacity and liquidity restrictions that a smaller investor may not face. In turn, that affects the strategies a large asset owner is able to choose and implement.
These are very important. They are one of the building blocks that enable an organization to deliver a long-term strategy. It is very important to have your investment beliefs and investment strategy in tune with each other. Then you are in the best position to make good decisions in the future. Where poor decisions are made, value can be destroyed.