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The Essentials of Factor Investing

Educational module for investment professionals

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Continuous Professional Development (CPD) is an important part of any advisor’s career, particularly as times change so rapidly. The speed with which factor investing strategies, in particular smart beta products, have imposed themselves in the investment landscape, has left many at a disadvantage when explaining factor investing to clients and prospects. 

The following module aims to bridge that gap. We invite financial professionals engaging with this course to digest the information, and then take an optional test at the end. We aim to present the module using clear language, charts, videos and a short case study to enhance the learning experience. Each chapter should take about 15 minutes to thoroughly digest, with a summary and the optional test aimed at reinforcing the knowledge.

A successful outcome, gaining a score of at least 12 correct answers out of 15 questions (80%) in the test, counts for two hours of CPD in your professional assessments. The educational module is already accredited by local and global institutes, including the CFA, Institute, IBF and FPA, with more to follow. Good luck!

1. What is factor investing?

You’ve probably heard of factor investing. But what does it mean exactly and how widespread has this investment approach become? In this chapter, you will learn:

  • The basic principles behind factor investing
  • When its foundations were laid
  • That factor investing has rapidly gained popularity among investors

Factor investing

Factor investing is about investing in securities featuring certain characteristics that have proved to deliver higher risk-adjusted returns than the market over time, following a fixed set of rules. In other words, it is based on the systematic exploitation of a number of premiums, called factor premiums, that have shown to be robust over time and across different markets.1

An example of this is the value factor: securities that are attractively priced relative to their fundamental value, for example stocks exhibiting a low book-to-price ratio, tend to outperform in the long run.

Factor premiums

Factor premiums have been extensively documented in academic literature for over four decades. Although they were initially discovered in the stock market, these premiums can also be found in most asset classes, including bonds, currencies and commodities. In fact, factor investing can be applied both within and across multiple asset classes.

A history going back four decades

Capital Asset Pricing Model

The origins of factor investing date back to the 1970s, when empirical studies started challenging the prevailing assumptions of the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) for equities. These financial theories assume that markets are efficient, that investors are rational and that more risk leads to higher returns.

According to the EMH, it’s impossible to consistently beat the market because all participants are rational and always have access to all relevant information, to which they react instantaneously. As a result, securities always trade at their fair value, making it impossible for investors to either buy undervalued securities or sell them at inflated prices. In practice, of course, market participants don’t all receive or react to information simultaneously, and they don’t always act rationally.

Although the empirical foundations of factor investing were laid over 40 years ago, its real breakthrough came in 2009 with the publication of the Evaluation of Active Management of the Norwegian Government Pension Fund – Global report.2 This groundbreaking paper analyzed the performance of one of the world’s largest sovereign wealth funds after it suffered heavy losses as the global financial crisis deepened in 2008.

Authored by three finance professors – Andrew Ang, William Goetzmann and Stephen Schaefer – the report showed that the performance of the fund’s active managers did not actually reflect their true skill. Rather, it could in large part be explained by the fund’s implicit exposure to a number of factors. Based on their findings, they recommended a long-term strategy incorporating an explicit top-down exposure to proven factors to maximize returns.

Factor investing today

Systematic

In the ensuing years, prominent institutional investors have publicly embraced more systematic approaches to portfolio allocation and security selection based on these insights. Factor investing has rapidly gained popularity among professional investors around the world. Asset managers and market index providers have also dived in and increased the breadth of their offering in this field.

Smart beta, quant and factor-based strategies

Estimates of the amount of money invested in factor strategies vary from one source to another, ranging from USD 1 to 2 trillion globally in most cases. In a report published in October 2017, Morgan Stanley estimated that almost USD 1.5 trillion was invested in smart beta, quant and factor-based strategies and that assets under management have been growing by 17% per year on average since 2010.

Figure 1: Smart beta adoption percentage by region

Source: FTSE Russell, Smart beta: 2018 global survey findings from asset owners

According to a 2018 survey by asset manager Invesco, factor allocations accounted for approximately 16% of total portfolio allocations of institutional asset owners having adopted factor investing. According to another survey by FTSE Russell, 48% of asset owners worldwide have implemented smart beta, in other words factor-based strategies, in their portfolios in 2018.5

Table 1: Three key concepts

The definitions of concepts such as quantitative investing, factor investing, or smart beta are far from set in stone. Indeed, views on what these terms mean can vary significantly from one asset manager to another, and from one investor to another. In the table below, we attempt to clarify what we mean when we use them.

Quant investing

Quant investing can be defined as the use of quantitative data analysis and rules-based securities selection models to build portfolios in a systematic way. Contrary to fundamental investing, where the portfolio manager remains the sole decision maker, quant strategies use a model as the main driver of security selection.

Factor investing

Factor investing is a form of quant investing that is based on the exploitation of academically-proven factor premiums. This can be implemented within and across many different asset classes. Factors represent certain security-specific attributes that explain the return and risk of a group of securities in the long run.

Smart beta

Smart beta strategies explicitly target factor premiums and represent an alternative to traditional market capitalization-weighted indices (beta). The term smart beta could, in theory, be used to describe any kind of factor-based strategy. However, it is often associated with generic factor strategies – typically marketed through exchange-traded funds (ETFs) – based on publicly available ‘smart beta’ indices.

Source: Robeco

To sum up, factor investing emerged from the first empirical tests of the CAPM in equity markets, in the 1970s, to become a widespread investment approach nowadays.

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1 In this module, we will only cover ‘style factors’, although some product providers also consider some macroeconomic variables such as ‘economic growth’ or ‘inflation’ as factors.
2 A. Ang, W. Goetzmann and S. Schaefer, ‘Evaluation of Active Management of the Norwegian Government Pension Fund – Global’, December 2009. Report prepared for the Norwegian Ministry of Finance.
3 Morgan Stanley Research, October 2017, ‘Quant Investing – Bridging the Divide’.
4 Invesco, November 2018, ‘Global Factor Investing Study’.
5 FTSE Russell, 2018, ‘Smart Beta: 2018 Global Survey Findings from Asset Owners’.

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2. Why is factor investing so popular?

Factor investing can be viewed as a third way of investing next to traditional fundamental active and passive strategies. This chapter shows:

  • How factor investing fits between active and passive
  • Why it is a proven concept
  • Why so many investors have embraced it

In recent years, active managers have been criticized over how much value they add relative to the fees they charge. Many investors have been turning towards passive strategies as a cheap way of gaining market exposure. Having accounted for just 20% of equity assets in the US at the start of the financial crisis in 2007, passive investments accounted for almost 45% by the end of 2017, according to Morningstar.6

The rise of passive has not been limited to US stocks. European and Asian equity markets experienced a similar uptrend, and passive has also been gaining traction in other asset classes. Yet passive strategies are far from perfect. They may appear to be cheap and prevent unpleasant surprises resulting from poor active calls. However, they ultimately lead to chronic underperformance relative to the market, once costs are taken into account.

Passive strategies

But there are other concerns too. For example, due to their public transparency, passive strategies are prone to arbitrage. And their recent growth in popularity entails a risk of overcrowding. Also, because passive investing ignores decades of academic insights on factor premiums, replicating the market index implies investing a significant part of a portfolio in securities with negative expected returns. Moreover, truly passive strategies cannot take sustainability considerations into account as they involve active investment choices.

Quantitative investment strategies

Meanwhile, the rise of computational power and the ability to store and process an ever-greater amount of data at low cost have profoundly changed the way financial markets operate. One of the most important transformations has been the emergence of quantitative investment strategies. The rise of quant has, in turn, enabled new breeds of rules-based active selection approaches to emerge. Factor investing is one such example.

Third way of investing

The issues inherent in active and passive strategies have been instrumental in the rise of factor investing. In fact, factor investing is seen by many investors as a third way of investing. It has features that are similar to passive investing, such as its transparent, rules-based and low-cost nature. But, like active investing, it aims to outperform the market.

The Guide to Factor Investing
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Figure 2: Factor investing: a third way of investing

Source: MSCI, ‘The foundations of factor investing’, December 2013.

Factor investing is not designed to fully replace market cap-based passive investing, nor does it fully replace traditional active management. Many different types of investors, both institutional and retail, have actually embraced it as a third way of investing. With this approach they aim to improve diversification and enhance returns without increasing costs.

A proven concept

Why has factor investing become so popular over recent years? The reason is simple: it works in practice.

Proven

There’s extensive7 evidence that strategies focusing on proven factors add significant long-term value for investors, helping to reduce portfolio risk, improve risk-adjusted returns and boost diversification. Targeting proven factors in an efficient way is clearly worth the effort, even after the effects of management fees, taxes, trading costs and investment restrictions. Allocating to multiple factors thereby increases the probability of success.

However, it’s important to bear in mind that there are many different approaches to factor investing, some more efficient than others, and that investment outcomes can vary greatly. The factor investing label encompasses a wide variety of investment solutions that can be put to work in many different ways, using a broad array of investment vehicles.

In short, factor investing offers a compelling alternative to traditional active and passive strategies. But, there are different approaches to factor investing, some more efficient than others.

6 See: https://www.morningstar.com/lp/global-asset-flows-report?cid=CON_RES0019
7 See for example: E. van Gelderen and J. Huij, ‘Academic Knowledge Dissemination in the Mutual Fund Industry: Can Mutual Funds Successfully Adopt Factor Investing Strategies?’, The Journal of Portfolio Management, 2014.

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3. The academic evidence for factor investing

Factor investing is based on thorough academic research, with over four decades of empirical research showing it to be a robust investment concept. This chapter explains:

  • How factor premiums were discovered
  • Which were the most important milestones for factor investing
  • How current research goes well beyond equities and bonds

CAPM

Prior to the 1960s, investors had very little understanding of the relationship between the risk and return of their investments. This changed with the development of the Capital Asset Pricing Model, or CAPM8, which assumes a linear and positive relationship between risk and return – greater risk should lead to higher return – and the possibility to optimize a portfolio’s return-risk profile on a curve called the efficient frontier (see Figure 3). But it wasn’t long before people started to question whether the CAPM always held true.

As soon as the early 1970s, empirical tests showed that the link between risk and return is weaker than the CAPM theory suggests. One of the first studies, performed by Robert Haugen and James Heins,9 showed that less volatile stocks had consistently outperformed more volatile ones over the 1929-1971 period.

Figure 3: The CAPM and the Efficient Frontier

Source: The Capital Asset Pricing Model: Theory and Evidence, Eugene F. Fama, Kenneth French, 2004.

In 1977, another anomaly was observed, as Sanjoy Basu documented the value effect.10 He ranked stocks according to their price-earnings ratio and found an inverse relationship between the price-earnings ratio of a stock and its return. In other words, stocks featuring a lower valuation tended to achieve higher returns than the CAPM would suggest.

From Fama-French to Norway

Three-factor model

By the middle of the 1980s, it was becoming clear that a number of factors other than market risk needed to be considered, and alternative models were developed. One of the most famous was the three-factor model developed in the early 1990s by future Nobel prize laureate Eugene Fama and fellow researcher Kenneth French.11 Their model, which essentially extended the CAPM, assumed that a stock’s average returns were strongly related to its size (market capitalization) and its valuation (book-to-market ratio), not just to its market exposure.

Figure 4: Selected factor investing milestones for equities and bonds

Source: Robeco

But what really helped factor investing to move into the mainstream was the study, already mentioned in Chapter 1, of the Norway Government Pension Fund’s performance during the market crisis of 2007-08. From that time, factor investing rapidly gained popularity among global investors, who were faced with similar issues and looked for ways to obtain a better-diversified portfolio at reasonable costs.

Research continues apace

Momentum factor

While Fama and French’s three-factor model quickly became one the most influential models, many other studies suggested that more than three factors are needed to accurately explain stock returns. In 1997, for example, Mark Carhart proposed adding a momentum factor to the Fama-French model.12 In 2015, Fama and French responded to these studies by adding two additional factors to their model: profitability and investment. The combination of the two is often referred to as the quality factor.13

Over the years, the number of academic studies showing that factor investing can also be applied to fixed income also rose dramatically, as large historical data sets on individual bonds became more widely available. Nowadays, the research effort is going well beyond stocks and bonds: more and more analysis into the role of factors is being carried out in other asset classes.14

After this chapter, you should understand the scientific grounding of factor investing, and how the most influential factor models emerged. You should also know that the research effort is ongoing.

8 The CAPM is an asset pricing model that established a linear relationship between risk (relative to the market) and return. It was introduced in the early 1960s by several academics independently: Jack Treynor (1961), William F. Sharpe (1964), John Lintner (1965) and Jan Mossin (1966).
9 R. Haugen and J. Heins, ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’, working paper, 1972.
10 S. Basu, ‘Investment performance of common stocks in relation to their price-earnings ratio: a test of the market hypothesis’, The Journal of Finance, 1977.
11 E. Fama and K. French, ‘The Cross-Section of Expected Stock Returns’, The Journal of Finance, 1992.
12 M. Carhart, ‘On Persistence in Mutual Fund Performance’, The Journal of Finance, 1997.
13 E. Fama and K. French, ‘A five-factor asset pricing model’, Journal of Financial Economics, 2015.
14 See for example: D. Blitz and W. de Groot, 2014, ‘Strategic Allocation to Commodity Factor Premiums’, The Journal of Alternative Investments.

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4. Which factors actually work?

Over the years, dozens of purported factors have been identified by researchers. But are all the anomalies included in the ‘factor zoo’ worthy of consideration? In this chapter, you will learn:

  • The criteria a proven factor should meet
  • Which factors are the most broadly accepted
  • The basic definitions of common factors

‘Zoo’ of new factors

In recent years, the combination of increased computing power, greater availability of data and rising interest among researchers has led to a dramatic rise in the number of purported factors reported in academic journals. Some experts have even warned about a so-called ‘zoo’ of new factors.15 However, many of these factors tend to be related to one another and are often just different, maybe more exotic, ways of measuring the same phenomenon.

Figure 5: Examples of concepts in the world of factor investing

Source: Robeco

Meanwhile, others only seem to work over short periods of time, or in a limited number of segments of the market. For example, a study by Campbell Harvey, Yan Liu and Heqing Zhu analyzed over 300 factors and found that most of these factors are likely to be ‘false positives’.16 Another recent study by Kewei Hou, Chen Xue and Lu Zhang also found that most anomalies reported in the academic literature failed to hold up when thoroughly tested.17

So what exactly is happening here? The problem is that when researchers analyze many different sets of data, looking for recurring patterns in returns, these patterns are likely to emerge purely by chance and still be statistically significant. So, some caution is needed.

What to look for in a factor

Actually, it is possible to reduce the number of anomalies included in the zoo down to a handful of truly relevant factors. So, rather than considering hundreds of possible explanations of an asset’s returns, investors should be selective and focus on a small number of proven factors.

Number of strict requirements

So how exactly should we choose which factors to invest in? To qualify as investable, a factor should meet a number of strict requirements:

Table 2. Requirements factors should meet

Performing

Producing better risk-adjusted returns than the broad market over the long term

Proven

Able to overcome any attempts (within academia and in-house research) to discredit its validity

Persistent

Observable in different markets, stable over time, and robust to different definitions

Explainable

Having a plausible economic rationale for its existence, with strong academic underpinnings

Executable

Implementable in practice and still outperform after the effects of trading costs and other market frictions

Source: Robeco

A handful of broadly accepted premiums

So, which factors actually work? Well, the list of factors each asset manager or index provider considers relevant can vary slightly depending on their own research and convictions. For example, some managers consider income – the tendency of high-income securities, for example high-dividend stocks, to outperform lower-income ones – as a standalone factor for equities. Meanwhile, at Robeco, we don’t treat income as a standalone factor, but we do include income-related variables in the definition of some of the factors we target, such as value.

Most providers stick to a handful of broadly accepted premiums. As an example, below is a brief overview of the different equity factors considered by some of the key players in the factor investing arena.

Table 3: Common equity factors

BlackRock
Value
Size
Momentum
Quality
Low Volatility

FSTE Russell
Value
Size
Momentum
Quality
Low Volatility
Dividend Yield

Robeco
Value
Momentum
Quality
Low Volatility

S&P Dow Jones Indices
Enhanced Value
Momentum
Quality
Low Volatility
Dividend Yield
Equal Weight

Invesco
Value
Size
Momentum
Quality
Low Volatility
Dividend Yield

SSGA
Value
Size
Momentum
Quality
Low Volatility

Research Affiliates
Value
Size
Momentum
Quality
Low Volatility
Income

Vanguard
Value
Momentum
Quality
Min Volatility
Liquidity

Source: Savvy Investor, ‘Factor Investing: An academic source of Excess Returns’, Special Report, 2018.

Value, momentum, low risk and quality

Another consideration is that while the most common factors typically apply to all asset classes, some asset managers or index providers also have a slightly different list of relevant factors for each asset class. In credits, for example, Robeco considers value, momentum, low risk and quality as a factor.

Table 4. Defining the most common factors

Factor

Defining

Value

The tendency of inexpensive securities, relative to their fundamentals, to outperform over the longer term.

Momentum

The tendency of securities that have performed well in the recent past to continue to perform well, and for securities that have performed poorly to continue to perform poorly.

Low risk

Refers to the observation that low-risk securities tend to earn higher risk-adjusted returns than high-risk securities.

Quality

The tendency of securities issued by sound and profitable companies to outperform those issued by less sound and profitable companies, and the market as a whole.

Size

The tendency of bonds issued by companies with little debt outstanding and small-capitalization stocks to outperform the market.

Source: Robeco

In short, although dozens of market anomalies have been reported in the academic literature, investors should stick to a small number of factors that have been thoroughly tested in practice.  

15 J. Cochrane, ‘Presidential Address: Discount Rates’, The Journal of Finance, 2011.
16 C. Harvey, Y. Liu and H. Zhu, ‘… and the cross section of expected returns’, The Review of Financial Studies, 2016.
17 K. Hou, C. Xue and L. Zhang, ‘Replication anomalies’, NBER Working Paper, 2017.

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5. Enhance returns or reduce risk?

Factor investing can help pursue two main investment goals: reduce risk and enhance returns. But how does that work in practice? This chapter explains:

  • The historical performance of proven factors
  • How factors can help achieve higher long-term returns
  • The basics of low-risk investing

Enhancing returns

Enhancing returns

We saw in Chapter 2 that one of the most important transformations in the financial industry in recent years has been the massive shift from active to passive investment strategies, but that this raises a number of concerns. For instance, although going down the passive route may be cheap and prevent unpleasant surprises from poor active calls, it leads ultimately to chronic underperformance once costs are taken into account. Passive strategies also expose investors to significant arbitrage risk (for more details, see Chapter 7).

Against this backdrop, many investors have turned to factor investing in a bid to achieve superior risk-adjusted returns while keeping costs relatively low. Figure 6 and 7 show the historical performance of some of the most commonly accepted factors for equities and bonds.

Figure 6: Historical performance of proven equity factors

Source: David Blitz, “Factor Investing Revisited”, Journal of Index Investing, 2015. Performance figures for generic US value-weighted factor portfolios from July 1963 to December 2014. Quality is defined as the equal weighted combination of the Profitability and Investment factor portfolios. This chart is for illustrative purposes and does not represent the performance of any specific Robeco investment strategy. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.

Figure 7: Historical performance of proven credit factors

Source: Robeco, Bloomberg. USD investment grade January 94-December 17. Decile portfolios constructed using Robeco factor definitions. Credit returns measured over duration-matched government bonds. This chart is for illustrative purposes and does not represent the performance of any specific Robeco investment strategy. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.

These graphs show that stocks featuring attractive value, momentum and quality factor characteristics achieve higher returns over the longer term. In the credit space this holds true for corporate bonds with attractive value, momentum and size factor characteristics. Investors can either focus on each one of these factors independently or target a combination of factors for more stable outperformance over time.

Reducing downside risk

In recent years, risk reduction has become a top priority for many investors. Products exploiting the low-volatility or low-risk factors could be an ideal tool to help them do so without foregoing return potential.

Higher risk-adjusted returns

Virtually unknown barely a decade ago, low-risk investing has in the ensuing years become a broadly accepted and adopted approach. The low volatility and low-risk factors are grounded in the empirical finding that securities generating stable returns relative to the broader market have achieved higher risk-adjusted returns than riskier ones over the longer term.18 Various studies have confirmed this effect holds true in equity markets across the world and also in other asset classes, in particular the corporate bond market.

Academics have proposed several reasons to explain this anomaly and why it is likely to persist in the future. The most frequently discussed explanations relate to the rational behavior of asset managers, whose performance is generally evaluated against a benchmark.

High tracking error

This is why asset managers tend to focus on being able to deliver outperformance and on minimizing relative risk. As a result, they tend to overlook low-risk stocks, which are characterized with market-like returns and high tracking error. Other explanations include common behavioral biases of investors, such as overconfidence and the incentive structures, as well as investment constraints faced by many investors, in terms of leverage, benchmark, etc. These arguments are applicable for all proven factor premiums.

To summarize, different factor exposures can help achieve different investment goals. Depending on their needs and priorities, investors can either seek higher returns or reduce potential losses.

18 See for example: D. C. Blitz and P. van Vliet, ‘The Volatility Effect’, The Journal of Portfolio Management Fall 2007.

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6. Additional benefits of implementing factor investing

Factor investing can also help achieve very specific purposes, such as those most frequently cited in the latest annual survey of asset owners by FTSE Russell (see Figure 8). This chapter will show you:

  • Some of the objectives leading investors to consider factor investing
  • The mechanics at work behind each objective
  • That different goals can be pursued simultaneously

Improve diversification

Diversification is often said to be the only ‘free lunch’ available to investors, and asset owners have long applied this principle by dividing their holdings across different asset classes and regions. But the dramatic increase in correlations between asset class returns during the market turmoil of the 2000s began to cast doubt on the benefits of traditional diversification frameworks.

Diversification benefits of factor investing

The quest for more robust diversification techniques has seen many investors turn to factor investing – and with good reason. Many empirical studies have demonstrated the superior diversification benefits of factor investing, compared to classic diversification across sectors, regions and asset classes.

For instance, a 2012 paper19 by Antti Ilmanen and Jared Kizer analyzing data on several asset classes dating back to 1927 reported that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than traditional asset class-based approaches.

Reduce costs

Increased cost awareness among investors has also played a crucial role in the success of factor investing over the past few years. Factor investing is about capturing proven factor premiums in a rules-based way, in order to generate superior risk-adjusted returns after costs compared to the broader market.

Rules-based approach

The rules-based approach to generating superior performance is generally achieved at a lower cost, therefore charging lower fees, than traditional active managers. This is why factor investing is regarded by many investors as a third way in between passive and active, as we discussed in Chapter 2. It is transparent and has relatively low cost like passive, but an outperformance objective, like active.

Get specific factor exposure

Another frequently cited goal is to gain exposure to a specific factor. This may sound like stating the obvious, but it reminds us that, well before the advent of factor investing as a popular approach in the late 2000s, many investors were already exploiting individual factor premiums. Value strategies are a good example.

For decades, prominent investors have advocated buying securities trading below their intrinsic value and many active managers have been offering so-called value strategies.20 With the advent of factor investing, many investors have turned towards this kind of approach, as a systematic and cost-efficient way to achieve the kind of exposures they were previously seeking with fundamental strategies.

Figure 8: Investment objectives that initiated evaluation of smart beta strategies

Source: FTSE Russell, ‘Smart beta: 2018 global survey findings from asset owners’, May 2018.

Generate income

The quest for higher and more stable returns has convinced many investors to turn to strategies featuring high-income characteristics. In recent years, as bond yields fell across the developed world, these strategies have been gaining considerable traction, in particular among those asset owners interested in factor investing.

Income-related variables indeed represent a key input in the definition of some of the most commonly-admitted factors. Carry is an obvious case in point. But this also holds true for other proven factors, such as value or quality. That is why, in equity markets, value and low-risk investing typically involve selecting stocks from firms with high and stable dividends.

Other: achieving ESG targets

The implementation of factor investing is also a good opportunity to consider environmental, social and governance (ESG) aspects. Growing demand for sustainable investment solutions means asset managers are increasingly expected to take ESG criteria into account in their investment processes, without sacrificing returns.

Factor-based strategies are particularly suitable for smart sustainability integration. Their rules-based nature makes it relatively easy to integrate additional quantifiable variables in the security selection and portfolio construction process. From this perspective, a factor-based approach that integrates sustainability aspects in the investment methodology is not very different from a standard factor-based approach, where securities are included in a portfolio solely based on their factor characteristics.

For more information about Sustainable Investing, please visit our dedicated Essentials learning module.

The different goals mentioned in Chapters 5 and 6 are not mutually exclusive and can be pursued simultaneously. For example, investors can achieve both reduced downside risk and higher returns with efficient multi-factor approaches.

In short, on top of enhancing returns and reducing risk, factor investing can also be used to improve diversification, reduce costs, gain strategic exposure to a specific factor and generate income.

19 A. Ilmanen and J. Kizer, ‘The Death of Diversification Has Been Greatly Exaggerated’, The Journal of Portfolio Management, Spring 2012, Volume 38, Number 3.
20 See for example: Benjamin Graham and David Dodd, ‘Security analysis’, 1934

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7. What makes a factor strategy really efficient?

Not all products, labelled as factor strategies lead to the best investment outcomes. In particular, generic products can prove disappointing over time. In this chapter, you will learn:

  • Why generic factor investing products may not be the best option
  • How enhanced strategies address the pitfalls of generic products
  • That asset-specific challenges must also be considered

Multi-factor multi-asset solutions

Investors can choose from hundreds of factor-based products, from basic single-factor equity ETFs to sophisticated multi-factor multi-asset solutions. However, different factor strategies usually lead to different investment outcomes. Indeed, there is very wide dispersion in the performance of mutual funds exploiting equity factor strategies.21

Factor strategies need to be well designed and smartly implemented. Key challenges range from determining the right factor strategy – or set of strategies – for each investor, to ensuring that the portfolio is properly constructed. Finding the right balance between rebalancing the portfolio to maintain exposure to the relevant factors and keeping turnover and transaction costs low is also important. Generic factor strategies typically fail to address these challenges.

Inefficient generic products

For instance, many generic products provide only limited exposure to a targeted factor, or combination of factors, as well as unwanted negative exposures to other proven factors. The reason is that individual factors can have negative exposures to other proven factors, and generic factor definitions tend to overlook this issue. An example would be a low-volatility stock that is expensive (so it provides negative exposure to the value factor), or a quality stock that is in a downward trend (negative exposure to momentum).

What’s more, generic factor indices often use inefficient index construction processes that can result in unnecessary turnover, high concentration in some countries, sectors or industries, or excessive exposure to large-capitalization stocks.

Smart beta indices

Another major flaw of products that track public smart beta indices is that they are prone to overcrowding and arbitrage. Generic factor indices often publicly share their holdings and rebalancing methodology. This transparency comes at a cost for those who track these indices, as other market participants can identify in advance which trades are going to be executed and opportunistically take advantage of these moves. As a result, passive investors tend to buy securities at inflated prices and to sell them at depressed prices.

Table 5: Pitfalls of a generic approach and possible solutions

Pitfalls of generic approach Enhanced factor approach
Individual factors can have negative exposure to other proven factors Take into account other proven factors to avoid going against them
High trading costs Robust portfolio-construction process keeps turnover and transaction costs low
Concentration risk Research-based concentration limits (for region, country, sector and single stocks)
Arbitrage risk Keeping the strategy only transparent for clients

Source: Robeco

Efficient factor strategies, by contrast, are designed in such a way that factor premiums do not clash with each other. One way of achieving this is to apply enhanced factor definitions that ensure the securities providing positive exposure to one factor do not involve negative exposure to others. For example, it is possible to avoid overpriced low-risk stocks by also considering valuation criteria in the selection process. Efficient factor strategies also use portfolio-construction processes designed to mitigate turnover and keep trading costs under control.

Asset-specific challenges

In addition to the common implementation challenges for factor strategies we refer to in this chapter, it’s also important to acknowledge and address a number of asset-specific challenges. The corporate bond market provides good examples of this. A company typically issues only one or two types of stocks (common and preferred), but far more types of bonds. Bonds of the same issuer can differ in the maturity date, issue size, currency, and subordination.

These characteristics require careful treatment, especially in defining the factors and designing the investment process. Not all bonds from the same issuer are necessarily equally attractive: some might be cheap, others expensive. Another example is the liquidity issues that arise in the corporate bond market. Unlike equity markets, bonds differ substantially in terms of their liquidity. Some bonds trade every day, but others trade only infrequently. As a result, transaction costs can differ greatly from one issue to another.

Being able to tackle these kinds of asset-specific implementation challenges in the most efficient way can have a significant impact on performance. But it typically requires a sophisticated approach. Investors should consider this as a key differentiator between efficient and not-so-efficient factor investing solutions.

To conclude, most generic products expose investors to serious pitfalls, including chronic underperformance after costs and arbitrage risk. Enhanced factor strategies provide an answer.

21 E. van Gelderen and J. Huij, ‘Academic Knowledge Dissemination in the Mutual Fund Industry: Can Mutual Funds Successfully Adopt Factor Investing Strategies?’, The Journal of Portfolio Management, 2014.

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8. From theory to practice

Over the past decade, the financial industry has seen a structural shift as investors allocated funds from actively managed fundamental strategies to passive vehicles and factor investing strategies. How can investors benefit from factor premiums?

  • Why factor investing has been embraced
  • How factor investing can be implemented
  • Where to start when evaluating factor investing strategies

Predominantly institutional investors kicked off the rise of factor investing in the 2000s, as they acknowledged the academic evidence for the existence of factor premiums. Large financial institutions followed suit. The case of a large European private bank illustrates how factor investing has been embraced globally.

The bank had struggled with disappointing returns after the financial crisis and looked for products that offered better diversification. At the same time, they were looking to keep their average fee level relatively low. Allocating more to passive solutions was not desired as this would have a negative impact on return expectations. On the other hand, allocating more to active fundamental strategies would not match with their relatively low average fee objective. Therefore, they started looking for other sources of return and started evaluating different factor managers.

Their initial model portfolio for their private banking clients was 50% allocated to traditional active and 50% to passive strategies. To achieve their objective of active returns at still reasonable costs they moved their model portfolio allocation to 33%/33%/33% active (high conviction), passive and factor investing strategies as illustrated below. 

Figure 9: European private bank embraces factor investing in portfolio allocation

Source: Robeco

In the early 2010s, they jointly developed a multi-factor strategy with two global asset managers to be offered to their clients via their fund platform.

Where to start?

As a response to the increased awareness for and interest in factor investing, asset managers and index providers have been very active in launching factor-based products across different asset classes. Today, the industry offers a variety of ways to implement the proven principles of factor investing. These range from public smart beta indices to proprietary active multi-factor multi-asset solutions. With such a wide range of options available, how should investors go about choosing a factor strategy to invest in? To answer this question, they could start by answering a few pivotal questions:

  1. Bound to a benchmark?
    Allocating to factors can lead to significant deviations from the market portfolio and periods of relative underperformance compared to well-known market indices. For investors interested in factors, but wanting to stay relatively close to benchmark positions, enhanced index strategies would provide a solution.
  2. Which goals?
    Factor investing can help achieve a number of goals (see Chapters 5 and 6). These goals will require different factor exposures. For instance, investors looking for protection against a market correction might want to increase their exposure to the low-risk or low-volatility factors. Investors aiming for higher returns may look into more return-seeking factors such as momentum.
  3. Target single or multiple factors?
    Factors can be targeted individually, to fit the preferences made explicit by a client such as an allocation to the low-volatility factor for capital preservation. But one could also consider a strategy that provides exposure to multiple factors. For investors looking for more stable long-term outperformance across economic cycles, multi-factor strategies providing balanced exposure to a number of proven factors might be a more suitable option.
  4. Generic or enhanced approach?
    Generic factor strategies, often marketed through index funds or ETFs, may appear as a relatively straight-forward and low-cost solution. However, as mentioned in Chapter 7, going for the seemingly cheap option also means being exposed to a number of serious pitfalls such as relatively low factor exposures (i.e. lower return expectations), and being prone to arbitrage and overcrowding. This all could lead to disappointing investment results compared to enhanced factor strategies.
  5. Any sustainability considerations?
    Together with the massive rise of passive investing, growing demand for sustainable investment solutions is one of the major shifts that are currently reshaping the investment industry. For investors interested in both factors and sustainability, the upshot is that these two approaches work well together. More details on this specific topic are described in Chapter 6.

Factor investing works in practice and many investors embrace it. There are many ways to implement factors in a portfolio, and numerous products are available in the market that can deliver the desired results. 

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9. Summary

In this final chapter, we summarize the main points:

  1. Factor investing is based on academic evidence that investment strategies focusing on proven ‘factors’ of return outperform the market over the long term. In recent years, factor investing has rapidly gained popularity among professional investors around the world.

  2. Factor investing is not designed to fully replace active and passive management. Instead, it should be seen as a third way of investing. Factor investing works in practice and allocating to multiple factors increases an investor’s probability of success.

  3. The origins of factor investing date back to the 1970s, when empirical studies began to challenge the prevailing assumptions of the Capital Asset Pricing Model (CAPM). Factor premiums were first documented in equity markets, but factor investing also applies in credits, government bonds, commodity markets, as well as in the multi-asset space.

  4. Hundreds of factors have been reported, but many are variants of the same factor, or mere statistical coincidences. Most asset managers stick to a small set of proven factors such as value, momentum, low volatility, quality and size. A relevant factor needs to meet five key requirements. It should be performing, proven, persistent, explainable and executable.

  5. Factor investing can help investors to achieve two main goals: enhance long-term returns and reduce downside risk. Depending on their needs and priorities, clients can seek exposure to different factor premiums, or to a combination of factor premiums.

  6. Factor investing can also help to achieve other goals, such as boosting diversification, gaining exposure to a specific factor that is a strategic interest, generating income and integrating sustainability. All these goals are not mutually exclusive and can be pursued simultaneously, with efficient multi-factor strategies.

  7. Generic strategies, often labelled as ‘smart beta’, may look cheap but they remain far from optimal. They entail serious pitfalls, including negative exposure to proven factors, unnecessary turnover, concentration issues, as well as overcrowding and arbitrage risk. More sophisticated factor strategies can address these pitfalls.

  8. There are many ways to implement factors in a portfolio, and numerous products are available in the market that can deliver the desired results. The case of a large European private bank illustrates how factor investing has been embraced globally.
The Guide to Factor Investing
The Guide to Factor Investing
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The rise of Factor Investing - is it just a hype? (2017)

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What is the most appropriate definition of factor investing?

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Which one is true?

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What did the report on the Norwegian Government Pension Fund conclude?

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Why did factor investing become so popular?

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Passive strategies have advantages but also raise some concerns. Which of the below is a common concern?

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What is true?

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What is the right chronological order of academic factor investing milestones?

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Which requirements should a factor meet to qualify as investible?

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Many factors have been reported by academics, but which factors are the most commonly used?

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Looking at the historical performance of proven factors, what conclusion can be drawn?

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How can the anomaly of the low-risk factor best be explained?

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Which investment goals can factor investing help to achieve?

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Which are the most common pitfalls of generic factor approaches?

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What was the reason for the bank mentioned in Chapter 8 to investigate factor investing?

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Which item is most important when choosing a factor strategy?

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1
What is the most appropriate definition of factor investing?
Factor investing is an effective risk management approach
Factor investing is about investing in securities with characteristics that have proved to achieve higher risk-adjusted returns than the market
Factor investing is characterized by the assumption that markets are fully efficient
Factor investing is an effective risk management approach
Factor investing is about investing in securities with characteristics that have proved to achieve higher risk-adjusted returns than the market
Factor investing is characterized by the assumption that markets are fully efficient
2
Which one is true?
The adoption of smart beta (including factor investing) has grown the fastest in the US in 2018
The European asset owners have the highest adoption of smart beta with 61% in 2018
The global adoption of smart beta has dropped slightly in recent years
The adoption of smart beta (including factor investing) has grown the fastest in the US in 2018
The European asset owners have the highest adoption of smart beta with 61% in 2018
The global adoption of smart beta has dropped slightly in recent years
3
What did the report on the Norwegian Government Pension Fund conclude?
That the performance of the fund’s active managers did actually reflect their true skill
That the performance could in large part be explained by the fund’s implicit exposure to a number of factors
That the portfolio was very well diversified
That the performance of the fund’s active managers did actually reflect their true skill
That the performance could in large part be explained by the fund’s implicit exposure to a number of factors
That the portfolio was very well diversified
4
Why did factor investing become so popular?
It builds on years of academic research and works in practice
It is a cheap way of gaining market exposure
The rise of computing power enabled the processing of a great amount of data
It builds on years of academic research and works in practice
It is a cheap way of gaining market exposure
The rise of computing power enabled the processing of a great amount of data
5
Passive strategies have advantages but also raise some concerns. Which of the below is a common concern?
Passive investing requires a high-breadth investment universe
Passive investing leads to chronic underperformance, relative to the market, once costs are taken into account
Passive investing applies unsophisticated factor definitions
Passive investing requires a high-breadth investment universe
Passive investing leads to chronic underperformance, relative to the market, once costs are taken into account
Passive investing applies unsophisticated factor definitions
6
What is true?
The CAPM is an asset pricing model that establishes an exponential relationship between risk and return
According to research from the 1970s, less volatile securities consistently outperform more volatile securities over time
Factor premiums were initially researched in the credit space due to the vast availability of data
The CAPM is an asset pricing model that establishes an exponential relationship between risk and return
According to research from the 1970s, less volatile securities consistently outperform more volatile securities over time
Factor premiums were initially researched in the credit space due to the vast availability of data
7
What is the right chronological order of academic factor investing milestones?
Low volatility, value, size, momentum, three-factor model, quality
Size, value, low volatility, momentum, three-factor model, quality
Low volatility, value, momentum, size, quality
Low volatility, value, size, momentum, three-factor model, quality
Size, value, low volatility, momentum, three-factor model, quality
Low volatility, value, momentum, size, quality
8
Which requirements should a factor meet to qualify as investible?
Performing, proven and persistent, well-known
Proven, persistent, simple, explainable, executable
Performing, proven, persistent, explainable and executable
Performing, proven and persistent, well-known
Proven, persistent, simple, explainable, executable
Performing, proven, persistent, explainable and executable
9
Many factors have been reported by academics, but which factors are the most commonly used?
Value, momentum, low risk, quality, size
Value, momentum, low risk, quality, and liquidity
Momentum, seasonal trend, low risk, quality, size
Value, momentum, low risk, quality, size
Value, momentum, low risk, quality, and liquidity
Momentum, seasonal trend, low risk, quality, size
10
Looking at the historical performance of proven factors, what conclusion can be drawn?
Equity stocks with value, momentum and quality factors outperform over time
Factors cannot be found in the credit markets
Equity stocks with low-risk characteristics generate lower returns in the long run
Equity stocks with value, momentum and quality factors outperform over time
Factors cannot be found in the credit markets
Equity stocks with low-risk characteristics generate lower returns in the long run
11
How can the anomaly of the low-risk factor best be explained?
Only by the behavioral biases of investors, such as overconfidence
Behavioral biases, incentive structures and investment constraints, among others
The anomaly simply can’t be explained
Only by the behavioral biases of investors, such as overconfidence
Behavioral biases, incentive structures and investment constraints, among others
The anomaly simply can’t be explained
12
Which investment goals can factor investing help to achieve?
Enhance returns or reduce downside risk
Improve diversification or generate income
All of the above
Enhance returns or reduce downside risk
Improve diversification or generate income
All of the above
13
Which are the most common pitfalls of generic factor approaches?
They often target novel, less-researched factors
They provide only limited exposure to the targeted factor or set of factors
High trading costs and low concentration in certain segments
They often target novel, less-researched factors
They provide only limited exposure to the targeted factor or set of factors
High trading costs and low concentration in certain segments
14
What was the reason for the bank mentioned in Chapter 8 to investigate factor investing?
Disappointing returns after the financial crisis and search for better diversification
Social proof from institutional investors and wealth of academic evidence
All of the above
Disappointing returns after the financial crisis and search for better diversification
Social proof from institutional investors and wealth of academic evidence
All of the above
15
Which item is most important when choosing a factor strategy?
Lowest possible management fee
Choosing between a single- or a multi-factor strategy
Enhanced sustainability integration
Lowest possible management fee
Choosing between a single- or a multi-factor strategy
Enhanced sustainability integration