Factor-based allocation has become increasingly popular in recent years. But how to implement it in practice still remains a puzzle for many investors. Two pitfalls which must be avoided are unintended sector biases and excessive concentration on a particular sector.
Factor-based investing has gained considerable traction over the past decade. Concepts such as ‘factor premiums’ or ‘smart beta’ have become popular buzzwords, and now appear frequently in mainstream financial media. Prominent institutional investors have also publicly embraced allocation to well-documented factors. But despite growing awareness as to the potential benefits, many still struggle with how to put such strategies into practice in their portfolios.
In the previous article in this series, which is dedicated to the major challenges investors face in factor investing, we advocated a comprehensive and balanced approach in terms of exposure to different premiums. Because factors can clash with each other and are virtually impossible to time effectively, investors must avoid any excessive or undesired exposure to individual premiums.
The same is true for geographic regions, countries and business sectors, as well as individual stock exposures. Portfolio construction processes that focus solely on factor premiums can lead to significant, unintended biases, especially in terms of sectors. In a recent whitepaper (1), researchers from the Scientific Beta/EDHEC-Risk Institute showed that portfolios targeting greater factor exposure also tend to focus heavily on a limited number of industries, and concentrate on fewer sectors overall.
For example, a strategy designed to capture the momentum premium without taking into consideration any other element, may rapidly lead to excessive concentration of the portfolio on a small number of industries that may be in vogue at the time. As a result, sector-specific developments can significantly undermine overall performance.
Concentration risk is especially important for generic factor-based strategies, particularly when they rely on the replication of popular smart beta indices (2). Many of these products do not have explicit concentration limits. The S&P 500 Low-volatility index is a good example. There are no constraints on sector weights, which can lead to huge concentrations. As a result, in December 2012, around 60% of this index was invested in only two sectors: utilities and consumer staples.
Investors take this issue very seriously. In fact, a FTSE Russell survey carried out in 2016 suggested that avoiding unintended sector biases ranked third among investor concerns regarding factor allocation.
Efficient factor strategies must integrate strict but workable concentration rules
Although the focus should remain on optimizing exposure to relevant factors, the merits of broad diversification across a varied selection of securities should not be forgotten. Robeco’s in-house research shows that adding constraints on sector weights to an unconstrained portfolio reduces concentration risk while not significantly altering returns, at least to a degree. At a certain point, however, concentration limits start to have a negative effect on performance.
As a result, there is a converse relationship between the return/risk ratio of a portfolio and concentration levels, as measured by the allowed active weight for regions, countries, sectors, size groups or single stocks. This means that an optimal level of concentration exists that must be taken into account by investors.
Efficient factor strategies should therefore not only focus on maximizing exposure to premiums, but should also prevent unintended geographic or sector biases, as well as undue concentration on some single stocks or sub-segments of the financial markets.
To ensure appropriate diversification, all of our quantitative strategies are subject to strict but workable concentration rules, that lead to a varied selection of stocks or bonds while avoiding excessive sector and country tilts.
For our Factor Investing Solutions and our Conservative Equities portfolios, for example, we apply position limits that allow an absolute deviation from the MSCI Index weight for regions, countries and sectors that does not exceed 10%. For size groups (large, mid and small caps), the maximum allowable deviation is 20%. Meanwhile, the maximum percentage that can be invested in a single stock is 2%.
ll these concentration limits are based on thorough research. They are monitored by the portfolio management team as well as Robeco’s Compliance department. They are intended to further reduce concentration risk while maintaining focus on the primary objective: achieving the best possible exposure to the targeted factor premiums.
The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).
This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.
This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.