Factor-based strategies can enhance returns over the longer term. Second article of a series on how factors can help investors achieve specific goals.
One of the most important transformations experienced in recent years by the financial industry has been the massive shift from active to passive investment strategies. Decades of frequently disappointing active manager performance and increasing cost awareness have pushed many investors towards low-cost indexed strategies, often through the use of ETFs.
But this shift raises a number of concerns. For instance, going passive may be cheap and prevent unpleasant surprises from wrong active calls, but it also leads to chronic underperformance, once costs are taken into account. Moreover, passive strategies expose to significant arbitrage risk.
In this context, many investors have turned to factor investing in a bid to achieve superior risk-adjusted returns while keeping costs relatively low. In fact, a 2017 FTSE Russell survey of asset owners found that return enhancement ranked second among the top investment goals that lead them to consider factor-based strategies.
Factor investing has its roots in the vast body of empirical evidence that has been accumulated over more than four decades and documents the existence of various factor premiums in financial markets. These premiums can be systematically harvested to enhance the risk-return profile of a portfolio.
Factors can be associated with different characteristics of a financial security – such as its valuation, or its price momentum and volatility – that are important determinants of its long-term risk and return. Securities featuring certain factor characteristics have shown to have higher risk-adjusted returns than the market portfolio over the longer term (see Figure 1).
Despite its deep academic rooting, the real breakthrough in factor investing did not come until 2009 and the publication of a research report1 by professors Andrew Ang, William Goetzmann, and Stephen Schaefer. Analyzing the performance of one of the world’s largest sovereign wealth funds, which invests Norwegian oil revenues, the three academics showed that rather than reflecting true skill, the added value of the fund’s active management could in fact be explained by implicit exposures to systematic factors.
The authors also advocated the adoption of factor investing because of the long investment horizons of factor premiums. From that moment, the concept rapidly gained popularity among professional investors around the world who were faced with similar issues and sought an efficient and prudent way to systematically capture factor premiums.
Implementing factor investing is not a binary “yes” or “no” decision. Once they decide to go for factor investing, investors have to make a number of important decisions that are crucial to the success of their strategy. The first concerns which factors to allocate to. Although this may seem very basic, it is far from a trivial consideration. Most product providers focus on a handful of well-vetted factors, but academics are still debating whether looking at the more exotic, recently reported factors adds value.
The second major element investors need to decide on is the weight they wish to give to each factor in their strategic allocation mix. This issue is also hotly debated among academics and practitioners. While some argue factor exposures can be timed tactically and factors showing the best short-term potential should be given priority, others – including Robeco – acknowledge that timing is difficult and advocate a balanced exposure, unless a specific factor is of strategic interest.
The third crucial step is to make sure the chosen solution efficiently harvests factor premiums. This means being able to identify the risks to which you will be exposed when you engage in factor investing and to understand which risks are necessary and which are not. This is why it is also very important to be able to develop tools that help identify and eliminate unrewarded risks.
1 A. Ang, W. Goetzmann and S. Schaefer, ‘Evaluation of Active Management of the Norwegian Government Pension Fund – Global, prepared at the request of the Norwegian Ministry of Finance, 2009.
This series of articles aims to illustrate the wide variety of investment goals that can be achieved through factor-based strategies.
Read all of the articles:
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