What is factor investing?

Factor Investing is a relatively new concept which is rapidly becoming mainstream. However, we sometimes encounter confusion and notice a lack of consensus on what Factor Investing really is and what sets it apart from traditional quantitative investment approaches.

Factor Investing is founded on the existence of various factor premiums. Well-known examples of factor premiums in the equity market include the value, momentum, quality and low-volatility premiums. The existence of these factor premiums has been extensively documented in the literature, and they have been shown to be robust over time and across different markets. Similar premiums have been documented in the corporate bond market and also in the multi-asset space, so Factor Investing is not necessarily limited to the equity part of a portfolio.

The initial evidence for the existence of factor premiums goes back multiple decades, so in that sense they are not new. Quantitative asset managers have developed various investment approaches to harvest these factor premiums. They have traditionally done so by creating proprietary multi-factor models, in which quantitative factors are combined in such a way that the resulting portfolio consistently generates outperformance over the market index. Crucial in this regard is that asset owners allocate to conventional asset classes, such as global equities, and leave it up to asset managers how to get the most out of factor premiums. Asset owners focus their efforts on selecting the offering with the best performance characteristics.

More recently, other investment approaches have come to the market. This includes index providers who entered the business by offering all kinds of indices designed to benefit from factor premiums. For instance, the MSCI Minimum Volatility index series specifically targets the low-volatility effect, while fundamentally weighted indices provide exposure to the value effect. In this way, factor premiums became alternative betas, or, more popularly, smart betas.

Although investors can passively track smart beta indices, it is important to realize that they are essentially active strategies, because they systematically deviate from the market index and require someone else to be on the other side of the trade. The difference with traditional quantitative strategies is that smart beta indices use a relatively simple and transparent investment approach.

The availability of smart beta indices made it relatively easy for asset owners to consider factor premiums next to traditional classes in their Asset Liability Management (ALM) or strategic asset allocation process. This is what we call Factor Investing: asset owners allocating strategically to factor premiums next to traditional asset class risk premiums, and essentially treating both as equal.

We strongly believe that there is no single optimal factor allocation as the optimal Factor Investing portfolio depends on investor-specific beliefs and preferences. For example, the low-volatility factor is very attractive for investors looking for downside protection without sacrificing return potential, such as pension funds aiming for funding ratio stability. However, it can be less attractive for clients who care more about maximizing return than about reducing risk and for clients who dislike the high tracking error involved with low-volatility strategies.

After choosing a strategic allocation to factors, asset owners have various ways in which to implement their Factor Investing strategy. A key decision is whether to follow public factor indices, such as a fundamentally weighted index or a Minimum Variance index, or make use of proprietary approaches. For an index-based approach one could follow an appropriate smart beta index for each factor. These compete with proprietary approaches, which either target various factors individually or multiple factors simultaneously using an integrated model.

We believe that although smart beta indices are a good way to obtain exposure to factor premiums, it is possible to do better by avoiding the pitfalls encountered with these indices:

• Smart beta indices do not provide the most efficient exposure to factors

• Smart beta indices can expose investors to unrewarded risks

• Smart beta indices targeting one factor often go against other proven factors

• Smart beta indices are vulnerable to overcrowded positions and index arbitrage

• Smart beta indices can involve more turnover than necessary

Robeco’s factor solutions are designed to offer more efficient factor exposures by specifically addressing these issues.