Factor investing debates: Are there any capacity issues?

Factor investing debates: Are there any capacity issues?

30-12-2019 | Insight

Even though factor premiums may be persistent, harvesting them in a consistent and efficient way is no mean feat. Advocates of factor investing argue that it has a much higher capacity than most traditional fundamental strategies. Yet , concerns about crowding have been raised.

  • Yann Morell Y Alcover
    Morell Y Alcover
    Investment Writer

Speed read

  • Capacity of factor strategies has become a topical issue
  • Most concerns about capacity relate to public factor indices
  • Proprietary active strategies help avoid this drag

These concerns arise from the idea that because premiums are public knowledge and have been widely documented in the academic literature, a growing number of investors will inevitably focus on a limited number of securities with attractive characteristics. So, while factor premiums may be persistent, this could lead to capacity issues for those looking to benefit from them.

Although some prominent academics argue that factor investing strategies have a very high capacity1, anecdotal evidence of overcrowding has also been reported and red flags raised. In a 2015 editorial published in The Journal of Portfolio Management, Bruce Jacobs warned that smart beta strategies are vulnerable to ‘crowding’, with increasing popularity posing a risk of overpricing and lower future returns2.

A year later, founder and chairman of Research Affiliates Rob Arnott co-authored a research paper provocatively titled ‘The incredible shrinking factor return’3. The study warned about the substantial slippage observed between theoretical and realized factor returns due to the costs of implementation. These included items that can be related to crowding, such as missed trades or bid-ask spreads.

More recently, Robeco’s Joop Huij and Georgi Kyosev showed how strategies based on popular factor indices such as the MSCI USA Minimum Volatility Index have suffered from chronic overcrowding and arbitrage. As trades are announced in advance, many market participants anticipate them, and investors who replicate these indices lose as much as 16.5 basis points per annum4.

Most of the red flags raised have to do with products based on publicly transparent factor indices

Two recent studies on low volatility by Robeco’s David Blitz, for instance, dispelled the crowding concerns associated with this popular factor. They showed that despite decades of research supporting low volatility investing, neither ETFs as a whole nor the more flexible, knowledge and opportunistic hedge funds have been positioned to exploit this factor. On the contrary5.

In fact, empirical studies suggest that when implemented properly, factor investing strategies have a very high capacity6. Some experts even argue that because of its systematic nature, factor investing has much larger capacity than most conventional active stock or bond-picking strategies, which tend to focus on small subsets of the investment universe.

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates

Public versus proprietary dilemma

In short, most of the discussion around potential capacity issues boils down to the public versus proprietary debate. While the early adopters of factor investing relied on proprietary strategies, most of the recent commercial push has come from generic approaches, so-called “smart beta” products, based on public factor indices.

These products have their merits. They are transparent and usually have very low fees. But they also have important drawbacks, in particular because – as mentioned earlier – they are prone to crowding. Most of that crowding comes from the fact that trades are publicly known in advance and that these trades are, by construction, concentrated on just a few rebalancing dates per year.

With strategies based on the MSCI Minimum Volatility indices, for instance, all trades must be carried out on the last business days of May and November. This severely limits the capacity of the strategy and explains the significant price distortions seen during the period between the announcement and effective rebalancing dates of these indices.

Active factor strategies can trade gradually, making full use of the liquidity offered by the market

Meanwhile, proprietary strategies may be less transparent and come with higher fees, but they have other advantages. One is that they can avoid overcrowding. While smart beta indices concentrate all their trades on just a handful of rebalancing dates every year, active factor strategies can trade gradually, making full use of the liquidity that is offered by the market.

In a recent simulation exercise7, Robeco researchers gradually rebalanced the MSCI Minimum Volatility indices by delaying trades. They found no loss in performance and what they characterized as a spectacular improvement in trade feasibility. Robeco researchers believe this holds true not just for the MSCI Minimum Volatility indices, but also for other smart beta indices, such as MSCI Quality and MSCI Value-weighted indices.

What should investors do about this? (The Robeco view)

So, while the capacity of factor investing may be large and factor strategies may not be inherently subject to overcrowding, some products appear to us to be seriously under threat. Investors should therefore always keep in mind crowding risk and focus on strategies with proper capacity management – something public indices typically lack as they are not designed for high capacity.

To illustrate this with a concrete example, Figure 1 shows the losses incurred by investors in the widely used MSCI Minimum Volatility indices, due to price reaction before additions and deletions. As we can see, crowding and other phenomena, such as arbitrage, can be very costly for investors, and quickly wipe out the benefits of factor exposures.

Source: Huij, J. and Kyosev, G., 2018, “Price Response to Factor Index Additions and Deletions”, working paper. The sample period is November 2010 to December 2015 and includes a total of 11 rebalancing moments. The table shows turnover, cumulative abnormal return, and performance drag of MSCI Minimum Volatility Index additions and deletions. Turnover is the sum of the weight of all additions or deletions in the relevant index. CAR (AD:ED-1) is the cumulative abnormal return from the announcement day to one day before the effective day. Performance drag is calculated by multiplying the turnover and CAR of additions and adding the negative of the product of turnover and CAR of deletions. The four indices used are the MSCI USA Minimum Volatility (USD) Index (US), the MSCI World Minimum Volatility (USD) Index (Global), the MSCI Europe Minimum Volatility (USD) Index (Europe) and the MSCI Emerging Markets Minimum Volatility (USD) Index (EM). Abnormal return is calculated as the total USD return of the stocks in excess of the average total USD return of all stocks in the relevant factor index. Performance drag is measured in basis points.

This also means that choosing a product based mainly on the fee charged by the provider, without considering practical implementation aspects, may not necessarily lead to the highest net returns. Fees are important but they should not be considered in isolation. This topic will be discussed in the next article of this series.

1 See, for example, Ratcliffe, R., Miranda, P., and Ang, A., 2017, “Capacity of smart beta strategies: a transaction cost perspective”, The Journal of Indexing.
2 Jacob, B.I., 2015, “Is smart beta state of the art?”, The Journal of Portfolio Management.
3 Arnott, R., Kalesnik, V. and Wu, L, 2017, “The incredible shrinking factor return”, working paper.
4 Huij, J. and Kyosev, G., 2018, “Price Response to Factor Index Additions and Deletions”, working paper.
5 See Blitz, D.C., 2018, “Are Hedge Funds on the Other Side of the Low-Volatility Trade?”, The Journal of Alternative Investments. See also: Blitz, D.C., 2018, “Are Exchange-Traded Funds Harvesting Factor Premiums?”, Journal of Investment Consulting.
6 See for example: Li, F., Chow, T., Pickard, A. and Garg, Y., 2019, “Transaction Costs of Factor Investing Strategies”, Financial Analysts Journal.
7 Blitz, D. and Marchesini, T., 2019, “The Capacity of Factor Strategies”, The Journal of Portfolio Management.

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:


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. 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:

  • 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 to be accessed by “professional investors” only (as defined in the Securities and Futures Ordinance (Cap.571) and/or the Securities and Futures (Professional Investors) Rules (Cap.571D) under the laws of Hong Kong). 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
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.

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 the “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