A key concern often voiced by factor investing and smart beta sceptics is the possible risk of overcrowding. According to critics, the growing popularity of factors will inevitably lead to excessive bets and the disappearance of premiums. Such prophecies, however, seem to be based on misguided intuition rather than serious empirical research. Rigorous analysis suggests overcrowding fears are clearly overdone, says David Blitz, Robeco’s Head of Quant Equity Research.
Do you think overcrowding poses a serious threat to factor premiums?
“In a nutshell, I think such concerns are exaggerated. Allocation to factors and factor-based strategies has been done for decades, but the premiums provided by these factors have not disappeared. Moreover, if there is a rational economic explanation for eligible factors, as I think there is, there is no reason to believe such premiums will disappear even if many investors are aware of their existence. The arguments that are used to justify overcrowding concerns are typically not evidence-based, but tend to be gut reactions. For instance, the rising valuation of low-volatility stocks is cited as evidence that too much money has been poured into these strategies, while a long-term historical perspective shows that current valuations are not unusual at all. For instance, low-volatility stocks were also more expensive than the market in the 1940s and 50s, when low-volatility investing was still a completely unknown concept.“
Could the rapid expansion of smart beta ETFs change that?
“In theory it could. But let’s take a look at the evidence. In a recent academic paper* , I analyzed factor exposures of a broad sample of US equity ETFs, by regressing their returns on the returns of various well-known factors, based on data recorded in late 2015. I found that many funds indeed offer a large positive exposure to factors, such as size, value, momentum and low volatility. As such, they can be considered suitable instruments for investors seeking to systematically harvest these premiums, except perhaps for the momentum premium. At the same time, however, I also found that many other US equity ETFs had a similarly large degree of negative exposure towards the very same factors. On balance, the exposures towards the size, value, momentum and low volatility factors turned out to be very close to zero. These findings clearly go against the idea that factor premiums are rapidly being arbitraged away by ETF investors. They also contradict the related concern that factor strategies could be turning into overcrowded trades.”
Still, impressive growth in assets under management targeting specific factors looks like a warning sign…
“Yes… and no. The increased popularity of low-volatility strategies is a good illustration of this. Low volatility was one of the first market anomalies to be identified. At first glance, investors looking only at the billions of dollars invested in ETFs who are specifically targeting this anomaly may rightfully be concerned about possible overcrowding. However, upon closer examination, the funds in question are found only to represent a small fraction of the total ETF market. Moreover, at the other end of the spectrum, you find a similar number of ETFs which provide exactly the opposite factor exposure, with a significant bias towards high-volatility stocks. These ETFs are typically sector-focused funds. They are obviously not labelled ‘high-volatility funds’ but they do effectively neutralize the exposure of the low-volatility ETFs. In other words, based on ETF data, one might just as well argue that high-volatility stocks are overcrowded, instead of low-volatility stocks. Or that both are equally overcrowded, in which case the concept of overcrowding also loses its meaning.”
What if some opportunistic investors start betting massively on one specific premium?
“That’s a possibility, but again, despite the fact that some factors have been identified for more than 40 years in the academic literature and are now very well-known in the investment industry, we do not see it actually happening. To illustrate this, in another recent paper, I analyzed the exposure of hedge funds towards low volatility, using indices from two leading providers, Hedge Fund Research and Credit Suisse, over the ten-year period from January 2006 to December 2015. Hedge funds are by nature both opportunistic and flexible. Therefore, one would expect them to actively bet on low-volatility stocks. But, as surprising as it may seem, this is not the case. On the contrary, the analysis showed very clearly that, despite their flexible approach to investing, these funds tend to bet strongly against the low-volatility anomaly. This is another indication that the low-volatility trade is still far from being overcrowded.”
Limits to arbitrage may not be the main reason
OK. But these findings also seem to refute one of the most frequently mentioned reasons that explain the existence factor premiums: limits to arbitrage.
“That is true. Investment restrictions faced by investors, such as constraints on leverage, short-selling and being evaluated against a benchmark, are often cited among the key reasons for the existence of factor premiums. But my analysis of hedge funds returns suggests this may not be the main reason after all, since these constraints do not really apply to this category of investors. Other explanatory factors that have been proposed in the academic literature, such as portfolio managers being willing to overpay for high-volatility stocks in order to maximize the expected value of their option-like compensation schemes, may be more important.”
This article was initially published in our Quant Quarterly magazine.
* “Are Exchange-Traded Funds Harvesting Factor Premiums”, David Blitz, 2017.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.