Over the past five years, FTSE Russell’s annual smart beta survey of asset owners has become a must-read. It provides useful insights on how factor investing is perceived by global institutional investors. To dig deeper into the results of the latest survey, we talked to Marlies van Boven, Managing Director of Research & Analytics at FTSE Russell.
The FTSE Russell annual survey has repeatedly shown that the rapid adoption of factor investing, and smart beta is a global phenomenon, but that Europe appears to be leading the way. How do you explain that?
“European asset owners were the earliest adopters of smart beta strategies. An explanation is that the large European institutional investors usually run money in-house and they often already have quant teams managing active quant strategies. I’m talking here about institutions based in Scandinavia or the Netherlands, where large asset owners tend to be quite sophisticated. For them, embracing smart beta was second nature. And as they did, other people got interested which led to a natural adoption across Europe.”
“In the US, things are a bit different, although there are very sophisticated asset managers offering smart beta strategies. But because asset owners tend to outsource more of their asset management, they did not initially have the internal resources to really grasp smart beta. This probably explains why the US market has been slower to embrace it.”
A similar phenomenon seems to be at work when it comes to ESG considerations within smart beta strategies. What’s your take?
“Again, this has to do with the same sophisticated European investors, that have been leading the way. In Scandinavia, for example, the regulations clearly encourage ESG adoption and the integration of sustainable goals into portfolios. In the UK as well, large financial institutions have an increasing mandate to incorporate ESG factors.”
“Meanwhile, in the US, there is more skepticism. It isn’t about Investors questioning whether climate change is real or not. They believe climate change should be addressed. But they are more interested in their underlying risk-adjusted performance so tend to focus more on financial goals. We are seeing that this is beginning to change though.”
One interesting finding of the latest survey is that new information and education still play a critical role in triggering the evaluation and the re-evaluation of smart beta strategies. But that off-the-shelf product availability has become almost as important. What’s the message here?
“As I said, many of the early adopters of smart beta were the large asset owners, which could manage strategies internally or through separate accounts. But smaller asset owners typically don’t have the same resources. They need off-the-shelf products. And because clients can have different views on how to combine factors or how to integrate ESG and smart beta, there can’t be a one-size-fits-all solution. So, as more products are made available, it is becoming easier for investors interested in factor investing to dip their toe in the water and try it out.”
“However, I think the investment industry also needs to keep up its efforts in terms of education. Educating clients on the role of smart beta in a portfolio is still very important. For most clients, it’s still quite difficult to decide how best to allocate to factors given their investment objectives and constraints.”
Another interesting finding is that asset owners seem to be focusing on a smaller number of strategies. In fact, over half of those who have a smart beta allocation actually only use one type of smart beta while, in the last survey, this figure was only 34%. Is this directly linked to the rise of multi-factor strategies?
“Yes, there is a clear link. Using individual factors is quite difficult because of their cyclical nature. It’s quite a natural development, therefore, to combine factors in a multi-factor solution, where you can achieve better risk-adjusted returns and smaller drawdowns.”
Capacity has indeed become a very topical issue
One of the most serious concerns raised by asset owners regarding smart beta related to capacity issues. In the latest survey, one in three respondents mentioned this point as an important barrier to implementation. Interestingly, the word ‘capacity’ had not appeared previously. Is this because capacity issues were simply not on their radar?
“We always try to adapt the survey to incorporate additional topics that are on investors’ minds, and capacity has indeed become a very topical issue. Measuring the capacity of smart beta strategies is quite difficult. Some studies have addressed this topic by comparing the amount of assets under management in factor strategies with the total amount of assets under management in the fund industry. The general finding is that passive funds’ share of investments is small. Other studies have focused on the breakeven point of a strategy, the point where trading costs wipe out any expected returns and found that the capacity of factor strategies is huge.”
In the latest survey, most of the respondents said they thought is was it impossible to time factors successfully. Was it the first time you included a question on timing in the survey? Do you have more insight into this topic?
“Yes, this was also a new question. With increasing discussion about factor timing, we thought it would be useful to test opinions on this. Incorporating factors into a portfolio is one thing but deciding on the relative weighting of the factors is another matter altogether. And given their cyclicality, trying to determine which ones are going to outperform requires some understanding of how factors work in different market regimes. You also need to figure out which regime you are in and do some macro analysis and forecasting. It’s not easy.”
Fixed income smart beta seems to be taking off but still very slowly. Are there too many hurdles?
“People are interested in transposing smart beta to fixed income, but it presents its own challenges and is still in its infancy. In many markets, bonds are still largely traded over-the-counter, so transparent prices are more difficult to determine. The amount of data available for research on factors in bond markets is also far smaller than for equities, where factors have been thoroughly researched for many decades.”
“Another difference is that the fee gap between traditional active and passive fixed income products is much smaller than for equities, so it is not as easy to position smart beta as a third option. Investors are showing interest and I am sure it will continue to evolve slowly over time to meet the specific features of bond markets.”
This article was initially published in our Quant Quarterly magazine.