When factors disagree

When factors disagree

30-09-2014 | リサーチ

Generic strategies designed to harvest a certain factor premium regularly conflict with other factor premiums. We find that the premiums associated with these strategies tend to shrink, sometimes even to zero, in these periods of factor disagreement. But enhanced factor strategies avoid stocks that are unattractive on other established factors and continue to deliver when generic factor strategies struggle.

  • Bart van der Grient
    Bart
    van der Grient
    Reseacher
  • Pim  van Vliet, PhD
    Pim
    van Vliet, PhD
    Managing Director, Head of Conservative Equities - Pim van Vliet
  • David Blitz
    David
    Blitz
    PhD, Executive Director, Head of Quant Selection Research

Speed read:

  • Generic factor indices often conflict with other established factors
  • Robeco’s enhanced strategy avoids stocks that are unattractive on other factors
  • Enhanced strategies offer stronger, more consistent performance

Two approaches: generic and enhanced

A factor investing strategy can be implemented in various ways. The main distinction that can be made is between generic approaches and enhanced approaches. The generic approach is to passively follow an index which is designed to actively benefit from a factor premium using a fully transparent, rules-based approach. A potential pitfall of such indices is that although they may provide exposure to a certain factor, they may, at the same time, be conflicting with other established factors. This is actually not unusual. For instance, value-tilted indices can become quite risky at certain times, thereby betting implicitly against the low-volatility premium, and momentum strategies have the structural tendency to select stocks which have become quite expensive.

Going against the value premium can also be a concern for generic low-volatility strategies, which, for instance, exhibit a higher P/E than the market in recent years. Robeco’s enhanced factor strategies are different, because one of their distinguishing features is that they are explicitly designed to avoid stocks that are unattractive on other established factors.

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The performance of generic and enhanced factor strategies

We have comprehensively examined the performance of both types of factor strategies. We found out that the more (less) a factor strategy is aligned with other factors, the stronger (weaker) its subsequent performance. In addition, the Robeco enhanced strategies turn out to offer a more consistent performance than generic approaches, because a key element of our investment philosophy is taking exposures to other factors explicitly into account.

Enhanced strategies deliver when generic strategies struggle

This improvement is particularly welcome when generic factor strategies struggle, because of their relatively unfavorable exposures to other factors. We observe that the enhanced factor strategies are still able to deliver in these scenarios. For instance, the enhanced momentum strategy generates over 3% outperformance when generic momentum is relatively expensive or risky and therefore hardly able to offer any added value. In a similar fashion, the enhanced low-volatility strategy manages to deliver 2-3% return over the cap-weighted index when generic low-volatility has a relatively high valuation or weak momentum and actually lags.

These results imply that it is crucial to properly align factor exposures when implementing a factor investing approach.

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