latamen
Factor investing: limited overcrowding risk

Factor investing: limited overcrowding risk

03-07-2017 | Research

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.

  • David Blitz
    David
    Blitz
    Head of Quant 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.

Stay informed on Quant investing with monthly mail updates
Stay informed on Quant investing with monthly mail updates
Subscribe

Download the research paper

Disclaimer:

This report is not available for users from countries where the offering of foreign financial services is not permitted, such as US Persons.

Your details are not shared with third parties. This information is exclusively intended for professional investors. All requests are checked.

Important information

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.

I Disagree