How important are factor tilts? And what’s the long term evidence on factors? Elroy Dimson chairs the Newton Centre for Endowment Asset Management at Cambridge Judge Business School, and is Emeritus Professor of Finance at London Business School. We spoke with him about the current state of academic research in that particular field and the appetite for factor-based and smart beta investment strategies.
Your work provides compelling evidence for the existence of an equity risk premium. Do you think the evidence for factor premiums is just as convincing?
“I think there is a difference. My work, together with Paul Marsh and Mike Staunton, shows it is difficult to measure precisely the equity risk premium. And, from that point of view, factor premiums are almost certainly estimated with greater error. I do not favor seeking exposure to a large number of factors. One should be considering premiums that are well supported by academic evidence across multiple markets and over multiple research periods.”
Factor investing has become increasingly popular among investors. Do you think we have enough hindsight from an academic research point of view?
“There is considerable scope for investigations in this field. Research shows that factor premiums tend to be smaller ‘out-of-sample’. That is, premiums tend to be smaller when the data analyzed is not the same as that which initially revealed the factor. Several papers have been published over the past couple of years highlighting the disappointing performance of many factor strategies after the research findings have been published. Professor Campbell Harvey, confirmed in his 2017 presidential address to the American Finance Association that ‘many of the research results being published will fail to hold up in the future* .”
Which factor premiums do you think are strongest, and which do you think are more questionable?
“If you would ask randomly any two experts to name five factors that they consider the most relevant or interesting ones, they would probably come up with different answers. Having said that, a few factors would likely be common to both lists. In a recent article** I and my co-authors focused our analysis on the following factors: size, value, income or yield, volatility and momentum. Why these? Well, we always look at data globally and over long periods of time, which is a distinctive feature of how we like to work. This obviously has an influence on the kind of data we choose to look at.”
Factor tilts are important. Asset managers and their clients need to be aware of their existence
Would you recommend institutional investors to allocate strategically not just to traditional asset classes, but also to factor premiums? To what extent? Monitoring factor exposure or actively seeking to capture premiums?
“It does depend on their time horizon and the costs they face, but I think investors should at least monitor factor exposures. Let me give you a concrete example of this. I was once a member of the investment committee of a charity which was hungry for income. It was made clear to the manager that the charity wanted more income because it could not spend out its capital. As a result, all other things equal, the manager tried to buy high yielding securities. And when high yield stocks did well, this fund did very well. When high yield stocks did not do so well, the fund would lag. This illustrates the fact that simply having a view about sustainable levels of spending can drive asset managers into unplanned factor exposures. I believe factor tilts are important and that both asset managers and their clients need to be aware of their existence. Even conventional investors, not just the very sophisticated, quant-oriented ones, need to assess and to take into account their exposure to different sources of risk.”
What is your view on the current smart beta frenzy and the numerous product launches?
“Often marketed as smart beta, factor investing has taken the investment community by storm. You can see its impact in the successive editions of the annual smart beta survey published by FTSE Russell. By 2017, nearly three-quarters of survey respondents had either implemented, or were evaluating or planning to evaluate, smart beta index products. Is the increasing enthusiasm for smart beta a passing fad – or, in your words, a frenzy? In the FTSE Russell survey, the primary objectives of institutional adopters have been return enhancement and risk reduction. Another important factor that asset owners cite is cost savings, which suggests that smart beta is increasingly perceived as an alternative to active strategies. Retail investors, such as buyers of ETFs, may well be pursuing the latest fashion, and smart beta is certainly in vogue among individual investors as well as institutions. But I don’t think it is a full blown frenzy – at least, not yet. There is still upside for promotors, suppliers and consumers of factor driven products to increase the penetration of factor strategies in the investment marketplace.”
This article is an excerpt of a longer text published in our Robeco Quarterly magazine. Read the full article here.
* In C. Harvey, "The scientific outlook of financial economics", Duke I&E Research Paper No. 2017-05
** E. Dimson, P. Marsh & M. Staunton, “Factor based investing: The long term evidence”, Journal of Portfolio Management (2017), Vol. 43, No. 5, pag. 15–37.