hongkongen
Putting factor investing theory into practice

Putting factor investing theory into practice

20-03-2018 | Interview

What are the basic steps investors should take to implement factor investing? What kind of products should they go for? Are products based on publicly available indices really the best option? Here are some of the issues we talked about with Robeco’s Joop Huij.

  • Joop  Huij
    Joop
    Huij
    Portfolio Manager, Head of Factor Investing Equities and Factor Index Research

Speed read:

  • Going for factor investing is not a binary decision
  • Products on offer differ greatly in quality
  • Transparency of public indices comes at a cost

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.”

1 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. J. Huij and G. Kyosev, ‘Price Response to Factor Index Additions and Deletions’, 2016.
2 J. Huij and G. Kyosev, ‘Price Response to Factor Index Additions and Deletions’, 2016.

This article is an excerpt of a longer interview published in our book of interviews with renowned academics “Exploring the world of factors”.

Important information

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.

Subjects related to this article are:

Disclaimers

1. General
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. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.

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:

  • Some Funds are subject to investment, market, equities, liquidity, counterparty, securities lending and foreign currency risk and risk associated with investments in small and/or mid-capped companies.
  • Some Funds are subject to the risks of investing in emerging markets which include political, economic, legal, regulatory, market, settlement, execution, counterparty and currency risks.
  • Some Funds may invest in China A shares directly through the Qualified Foreign Institutional Investor (“QFII”) scheme and / or RMB Qualified Foreign Institutional Investor (“RQFII”) scheme and / or Stock Connect programmes which may entail additional clearing and settlement, regulatory, operational, counterparty and liquidity risk.
  • For distributing share classes, some Funds may pay out dividend distributions out of capital. Where distributions are paid out of capital, this amounts to a return or withdrawal of part of your original investment or capital gains attributable to that and may result in an immediate decrease in the net asset value of shares.
  • Some Funds’ investments maybe concentrated in one region / one country / one sector / around one theme and therefore the value of the Fund may be more volatile and may be subject to concentration risk.
  • The risk exists that the quantitative techniques used by some Funds may not work and the Funds’ value may be adversely affected.
  • In addition to investment, market, liquidity, counterparty, securities lending, (reverse) repurchase agreements and foreign currency risk, some Funds are subject to risk associated with fixed income investments like credit risk, interest rate risk, convertible bonds risk, ABS risk and the risk of investments in non-investment grade or unrated securities and the risk of investments made in non-investment grade sovereign securities.
  • Some Funds can use derivatives extensively. Robeco Global Consumer Trends Equities can use derivatives for hedging and efficient portfolio management. Derivatives exposure may involve higher counterparty, liquidity and valuation risks. In adverse situations, the Funds may suffer significant losses (even a total loss of the Funds’ assets) from its derivative usage.
  • Robeco European High Yield Bonds is subject to Eurozone risk.
  • Investors may suffer substantial losses of their investments in the Funds. Investor should not invest in the Funds solely based on the information provided in this document and should read the offering documents (including potential risks involved) for details.

3. Local legal and sales restrictions
The Website is not directed at any person in any jurisdiction where (by reason of that person’s nationality, residence or otherwise) the publication or availability of the Website is prohibited. Persons in respect of whom such prohibitions apply or persons other than those specified above must not access this Website. Persons accessing the Website need to be aware that they are responsible themselves for the compliance with all local rules and regulations. By accessing this Website and any of its pages, you acknowledge your agreement with understanding of the following terms of use and legal information. If you do not agree to the terms and conditions below, do not access this Website or any pages thereof.

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
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.

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.

9. Privacy
Robeco guarantees that the data of persons accessing the Website will be treated confidentially in accordance with prevailing data protection regulations. Such data will not be made available to third parties without the approval of the persons accessing the Website, unless Robeco is legally obliged to do so. Please find more details in our Privacy and Cookie Policy.

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. 

Please click “I agree” button if you have read and understood this page and agree to the Disclaimers above and the collection and use of your personal data by Robeco, for the purposes for which such data is collected and used as set out in the Privacy and Cookie Policy, including for the purpose of direct marketing of Robeco products or services. Otherwise, please click “I Disagree” to leave the website.

I Disagree