Factor investing has strong empirical backing and will not fade away. Bernd Scherer is a research associate at EDHEC-Risk Institute, and head of wealth solutions for Bankhaus Lampe in Dusseldorf, Germany. He assesses the management of EUR 5 billion of private wealth portfolios. Much of his academic work has focused on asset allocation and portfolio construction techniques. We talked with him about his views on factor investing as a concept, as well as on the recent developments in this area.
How do you perceive the current developments around factor investing, from both an academic and a practitioner’s point of view? Have you seen any negative developments so far?
“Looking at academic research is a good starting point. Academic factor portfolios tend to be thoroughly cross-validated (across asset classes and over time) and built for asset-pricing purposes, not to generate maximum Sharpe-ratio backtests. As a result, the risk of data mining is much lower than for industry type research.”
“Having said that, product providers and investors need to be aware that there is no such a thing as a purely academic approach. Academia is diverse, with many opposing views, and constantly evolving. Factor investing is active investing, not the replication of academic papers.”
These days, we like to talk about the ‘factor zoo’, referring to the numerous anomalies that have been reported in academia. When it comes to selecting factor premiums, which ones would you consider relevant? More importantly, which of the more popular ones would you avoid and why?
"Factor investing in equity markets should revolve around the factors identified by Eugene Fama and Kenneth French in their famous five-factor model: value, size, profitability and investments, supplemented by low volatility and momentum. These cover most anomalies. I’m happy not to invest in the remaining part of the factor zoo, but believe some ideas can be used to improve existing factors. For example, you can go long momentum stocks that also display earnings momentum or combine dividend, accrual and earnings information when looking at dividend yields as a value signal.”
“I would avoid considering ESG as a factor on its own. It lacks any theoretical backing and to the extent serious academic research bothers to look into it, the results show that it is explained well by existing asset pricing factors. ESG either borders on the trivial – ‘don’t buy stocks where the management steals´ – or, at best, can be seen as contextualizing information.”
“We could ask: where are agency conflicts likely to be of most concern? Theory would tell us in large and heavily leveraged firms. This is a potential application for contextualizing governance scores. All risk management applications – reputational or regulatory risk – fall into this category. Relying purely on ESG is a sure road to financial underperformance. Investors will get less and pay more.”
Factor investing is active investing, not the replication of academic papers
If multi-factor investing was not an option and you could only choose one factor premium, which one would it be and why?
“I would opt for the market factor, of course. This factor still represents what the average investor should hold irrespective of the asset pricing model employed. In the absence of conditioning information (investors hedging demands) it is the portfolio to hold.”
Many academics have tried to understand why certain factor premiums exist. What is your opinion? Do you think risk plays a major role, or are behavioral causes more important?
“Behavioral finance and traditional finance look at the same data. They differ in their method of explanation. As an investor, I would want risk-based explanations to be correct. Simply because it would mean that risk premiums are here to stay. As an academic, behavioral finance reminds me of natural science in the 17th century. Things we didn’t understand at the time were considered an act of god. Not understanding does not equate to irrational behavior. This is slightly lazy and not an explanation I would start with.”
Do you see any warning signs that give investors reason to reconsider a purely factor-based investment approach?
“Not really. I’m afraid that the so-called ‘warning signs’ some people talk about may just be noise that is misleading investors. Factor investing is here to stay.”
Which research questions in the field of factor investing still need to be answered? And which interest you the most?
“What explains the cross-section of alternative risk premiums and which state variables drive conditional expected returns? Whoever unlocks these puzzles holds the key to factor allocation and factor timing. The problem is that we do not have much out-of-sample data on ‘alternative risk premiums’. Relying on backtested data is tricky, as backtests deliberately create time series that do not behave as we would expect in a capital markets equilibrium.”
Your book on portfolio construction, which was first published in 2002, is now in its 5th edition. How did the idea for the book develop? What inspired you to write it?
“Ever since I joined the industry, I’ve made a habit of writing short notes on the problems that I’m working on. I call this my personal Sudoku. This combined with a bad first marriage led to the first edition of the book. At the time, the importance of portfolio construction wasn’t as widely understood as it is now. Besides the famous book by Richard Grinold and Ronald Kahn, which addresses a different audience, there was nothing available.”
“So, my book addressed a niche market. Now, 16 years later, there are many good books on portfolio construction. While I believe the book still offers additional information , this shows how fiercely competitive and creative our industry is relative to others. Just attend some of the seminars held by organizations such as Inquire or Q-group and you will meet many outstanding individuals, and among them brilliant authors.”
This article was initially published in our Quant Quarterly magazine