After several years of rapid adoption, factor investing seems to be going through a rougher patch at the moment. How do you explain that? Is the tide reversing?
Benedikt Henne: “I would put your question into a long-term perspective. The earliest factor-based investments were made decades ago in the US, mostly in value and high dividend strategies. Later on, came minimum volatility and minimum variance investing. These strategies played a crucial role in the rise of factor investing in Europe.”
“But, in a way, many of these products were oversold at the time. Clients were told that minimum volatility would enable much higher returns at lower levels of risk than the market index. But they were not told that, far from being a core investment, these are actually low beta products that come with all kinds of macroeconomic sensitivities that might be unintended or might be unknown to the investor.”
“Logically, some of these early adopters have been disappointed. This is particularly the case for those who focused their investments on just one, two or three smart beta ETFs, high dividend and minimum volatility. The long-term performance of these products, over the last ten years or so, has actually been a little bit disappointing and more volatile than expected.”
“The real breakthrough of factor investing only occurred a few years ago, when investors started to become interested in multi-factor investing. This move was driven by large institutional investors, who were struggling to find enough successful high-conviction stock pickers to take all the liquidity they needed to invest. That’s because high-conviction managers tend to be capacity constrained.”
“Large institutions such as sovereign wealth funds and large pension funds were very much interested in high-capacity strategies such as factor investing, as these enabled them to get away from the benchmark. Moreover, when they looked at their overall portfolio, adding up all their high-conviction portfolios, they often discovered that the aggregate positions were actually quite close to the index. Getting active exposure was a tremendous challenge for these large institutional investors.”
Even if we go through a disappointing period, the relative performance of portfolios will remain driven by factors
“But they did their homework and analyzed their portfolios, and found that they had implicit factor exposures and tended to be ‘underdiversified’. They concluded, therefore, that they should be actively managing these exposures. This is why, contrary to what we’ve seen with single-factor smart beta investing, this move towards multi-factor investing will continue.”
“Even if we go through a disappointing period, the relative performance of portfolios will remain driven by factors. For large institutions, this means there is no escape from factors and, therefore, from factor investing – either implicitly or explicitly. First, because allocating to high-conviction ‘alpha’ managers is not an option, as their capacity is just too limited. Second, because the factors will inevitably come back at them at the aggregate portfolio level.”
Joop Huij: “Another very important aspect I’d like to mention is that most of the rougher patch has had to do with the poor performance of value strategies in developed markets. Value is one of best-known and most vastly documented factors. Empirical studies point to a large long-term premium for value stocks.”
“But what we have seen over the past couple of years or so has been a very strong outperformance by growth stocks instead. Naturally, this streak of poor performance was not anticipated by most active asset managers. But, from a historical perspective, it is not really surprising. We’ve seen similar periods of growth-stock outperformance in times of benign economic and monetary conditions.”
“This was the case a century ago in the aftermath of the Great Depression in the 1930s and right after World War II. This was also the case during the tech bubble of the 1990s and right after the global financial crisis 10 years ago. So, we have seen similar situations in the past and I would not consider the recent underperformance as a black swan for value investing.”
“The only unusual thing this time is that we are in a fairly late phase of the economic and market cycles compared to previous episodes of poor value performance. This is perhaps the most surprising element.”
“To follow up on one of the points Benedikt Henne raised, I also think the disappointment of some investors has been caused by the fact that early adopters often focused on single-factor, rather than multi-factor investing. As it is so well documented and so intuitive, value has logically been a favorite among investors. And those who embraced this as a single-factor approach some years ago have been suffering over the past years.”
“Meanwhile, multi-factor investing has only gained in popularity over the past four or five years. And those investors who chose to diversify their exposures across multiple factors such as low volatility, quality, and momentum have been able to weather the recent underperformance of the value factor much better.”
You mentioned the capacity constraints of high-conviction managers. But what about factor investing strategies? Some people have been warning about potential capacity issues leading, for example, to phenomena such as overcrowding. What’s your view?
Joop Huij: “Obviously, factor investing strategies have a much higher capacity than typical high-conviction stock-picking strategies. And if your question is about a potential crowding of factors and whether some factor premiums could be arbitraged away, then you have to consider the reasons why factors exist in the first place. This is a very fundamental debate.”
“Are factors risk factors? In other words, are factor premiums a reward for risk? If the answer is yes, factor premiums shouldn’t disappear, because they are rational compensation for risk. The premium might evolve over time, but that would have more to do with, for example, a change in an investor’s utility function.”
“Another possible interpretation is that factor premiums are the product of investors’ behavioral biases, specifically irrational behavior. And, in that case, once these irrational behavioral patterns have been documented, investors should be able to learn and adjust their practices. Then, factor premiums might fade and even disappear.”
“In practice, however, we find very little evidence supporting risk-based or irrational behavioral explanations. On the contrary, we find these patterns can better be explained by rational investor behavior. For example, investment managers are likely to avoid low-beta stocks as their compensation package better matches strategies that increase their portfolio’s up-capture potential (high beta) rather than lowering the down-capture potential (low beta).”
“This so called ‘agency theory’ clearly indicates how rational behavior can be a source of factor premiums. And, most importantly, we don’t see this behavior disappearing. In fact, in some cases, we even see it becoming stronger and stronger. Therefore, we don’t expect anomalies to fade away.”
“I don’t mean that behaviors don’t change. We do see some changes. For example, some large institutions have adjusted their investment strategies in order to benefit from these behavioral patterns. But the amount of money that is allocated to this kind of strategy remains extremely small for now. In absolute terms, it might seem like a lot of money, but in relative terms this is very little.”
“That might change, like with passive investing, which has grown tremendously over the past three decades. But we’re not there yet, by far. So, while overcrowding is something you definitely want to take seriously, for now this phenomenon has more to do with the way you implement factor investing than with the potential disappearance of factors.”
Benedikt Henne: “Generally speaking, I also think the capacity of most factors is quite large, provided you don’t restrict yourself to a small set of factors and you are flexible enough to buy a large number of smaller names that may not be included in the large-cap factor indices but also provide exposure to the factor.”
“Moreover, I think one should keep in mind that traditional fund managers are, by far, the largest buyers of factors that are currently in fashion. For example, they are by far the most important buyers of high-quality stocks – much more than the high-quality ETFs available in the market – and they generate the bulk of transaction volumes.”
“They also tend to focus on a relatively small number of stocks, because covering and analyzing stocks from a fundamental perspective is costly and time consuming. This, in turn, causes capacity issues. But it’s not the factor investors’ fault. It’s just because, in today’s uncertain macroeconomic environment, too many people are focusing on a very limited number of stocks.”
Broad-based factor strategies have the highest capacity that is available for any strategy in the equity market
“Meanwhile, broad-based factor strategies have the highest capacity that is available for any strategy in the equity market. This is actually one of the main reasons why large institutional investors look for a broad-based implementation of factor strategies. As I said earlier, in a way, this is the only means for them to place large amounts of money into active strategies.”
This is excerpt of a longer interview. Read the full article.
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