Most of your empirical research of the past few years has had to do with very practical implementation aspects of factor investing strategies. How has the perception of this kind of approach among investors changed in recent years? Are there any major trends you could pinpoint?
“Developments have indeed taken place very quickly in recent years in this field. Personally, I see three major trends in the way factor investing is being considered these days. The first I would mention is that investors increasingly want to incorporate factor investing into their portfolio, but may not necessarily be interested in the more traditional active strategies. Implementing factor investing through index-based products is becoming extremely popular.”
“Another important trend that I see at the moment is the rise of multifactor strategies. While initially investors tended to allocate to one particular factor they were interested in, say value or low volatility for example, they are increasingly demanding solutions providing exposure to multiple premiums. This is a way for them to reduce stress in years when one particular factor delivers below-average performance.”
“The third trend I see in the market is the rise of multi-asset factor investing. There is a growing demand for an implementation of factor investing strategies across multiple types of assets. And this is consistent with the fact that factors should be empirically well-documented and falsified over long periods of time, and across different markets and asset classes.”
For investors interested in factor investing, where should they start? What key considerations should they focus on?
“The first thing investors need to realize – and I think most of them do by now – is that implementing factor investing is not a binary decision. It is not just a matter of deciding whether to go for factor investing or not, and then not really caring about how to go about it and simply looking for the cheapest solution on offer. I think more and more investors are realizing that the choices made after the decision to go for factor investing are of crucial importance to the success of their strategies.”
“The first important choice they will face is to determine the factors they should strategically allocate to. This may seem very basic, but it is far from trivial, and prominent academics are still debating this issue. Some experts argue that there are only two relevant factors, others argue that there are six factors, and others that there are 400 factors. So, for an investor, the related question is of course: when is a factor relevant?”
“At Robeco, we have actually conducted a lot of research on this topic. We have basically tested the more exotic factors and their effectiveness, comparing them to the effectiveness of a handful of more traditional factors. What our research1 indicates is that the only factors that work - taking into account trading costs, taxes and all kinds of practical implementation restrictions - are those that have been thoroughly falsified in the academic literature.”
Any other important aspect you would highlight?
“Yes. The second major element investors will need to decide on is the weight they wish to give to each factor in their strategic allocation mix. I believe diversification is certainly one of the most important things when it comes to factor investing, and I would always recommend a factor mix that is well diversified across the factors.”
“The third crucial step for investors opting for factor investing will be to make sure the solutions they choose efficiently harvest factor premiums. This implies 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 risks are not. This is why I also think it is very important to be able to develop tools that will help to identify unrewarded risks and take them out.
Factor-based strategies must be evaluated over a full business cycle.
Given the current appetite for factor investing, isn’t there a risk of massive disappointment, in particular if factor strategies suddenly have to go through tougher times in terms of performance?
“My perception is that most investors realize that when they make a strategic allocation to a factor, just like when they make a strategic allocation to equities, for example, they can’t expect returns to be positive each and every year. Factor-based strategies must be evaluated over a full business cycle. Also, I think that investors now have a better understanding of the concept of diversification, which they appreciate. I say this because what we have seen over the past few years is that while some factors actually did quite well, others did not.”
Still, given the significance of current inflows into factor investing strategies, don’t you fear this trend might backfire?
“Well, this is often what you see when it comes to innovation. Initially, there is always an early adoption phase, and now we see that factor investing is becoming very popular. As a result, more and more asset managers are entering the factor investing arena and the product offering is booming. It seems inevitable that some investors will become disappointed.”
“One reason for this is that there is quite a large dispersion in the quality of the products that are on offer. And it will take some time before the realized returns actually reveal the best quality products. As time goes by, there will probably be a shakeup, which won’t necessarily be a bad thing. But there is also a more worrying aspect. This has to do with the flurry of generic, index-based products, often marketed as ‘smart beta’.”
“Here is why: when you ask investors why they have invested in those index-based products, you typically get two answers. The first one is ‘low fees’, which is difficult to disagree with. As an asset owner, you logically want to pay low fees. The second answer you get is ‘transparency’, which is also difficult to disagree with. As an asset owner, you like to be in control.”
“But what most people do not realize is that the transparency provided by these indices is not exclusive to them. It is public transparency and this means that other investors, including proprietary trading firms and hedge funds, can identify in advance which trades are going to be executed and can opportunistically take advantage of this.”
And this might end up weighting on the performance of those who invest based on these indices, right?
“Exactly. And to me this is a very serious concern. To check whether this is already happening and what it means for index investors, we set up a large research project at Robeco. And together with my colleague Georgy Kyosev we ended up publishing an article2 on this topic that has been presented to the American Finance Association in Philadelphia early 2018.”
“Our conclusion is that there is strong empirical evidence supporting that this front running is going on. At the same time, we also found clear signs of overcrowding in these public factor indices, which partly explains why products based on these indices are so cheap. Unlike an active asset manager who needs to close a fund to protect capacity, to protect existing investors from an inevitable decrease in average performance as the fund grows, an index provider does not have such responsibility. The same goes for asset managers offering products that replicate those indices.”
This article is an excerpt of a longer interview published in our book of interviews with renowned academics “Exploring the world of factors”.