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Factor investing: why implementation is important

Factor investing: why implementation is important

19-09-2014 | Insight

Factor investing is becoming more popular. Professional investors are increasingly considering investing strategically in certain parts of the financial market which realize better risk-adjusted returns over longer periods. The question is: “How can investors best implement this strategy?”

  • David Blitz
    David
    Blitz
    PhD, Executive Director, Head of Quant Selection Research
  • Joop  Huij
    Joop
    Huij
    PhD, Executive Director, Head of Factor Investing Equities and Head of Factor Index Research

Speed read:

  • Interest in factor investing has grown significantly.
  • Robeco researchers embraced factor investing at an early stage.
  • Robeco tries to gain insights on where the return and risk is coming from.
  • Innovation and risk reduction can go hand in hand.

Robeco was a pioneer in offering factor investing strategies which avoid the pitfalls associated with generic approaches. You need to implement such strategies well to be successful. Our prudent risk-controlled approach offers investors the best of both worlds.

Factor investing has its roots in solid scientific research. Leading academic studies demonstrate that, for example, value, momentum and low-volatility stocks, generate higher risk-adjusted returns. In the last five years, a systematic approach has been taken to explicitly allocate to these factors and investors have clearly benefited in terms of their risk-return profiles.

The question is how these academic insights can be incorporated into investment strategies. Robeco offers efficient exposure to one or more important factor premiums, including the value, momentum, and low-volatility factors. These three Robeco factor equity strategies are building blocks that can be flexibly applied to achieve optimal exposure. Robeco also offers the Factor Solution Fund, which combines all three strategies.

Two Robeco quantitative researchers, Head of Equities Research David Blitz and Senior Researcher Joop Huij discuss the dilemma which investors face when it comes to factor investing. On the one hand, investors want to take advantage of the latest ideas. But on the other hand, implementation can carry risks. Blitz and Huij explain the importance of a prudent approach.

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Early adoption

Interest in factor investing has grown significantly, says Huij. “It started with a 2009 research report compiled by professors Andrew Ang, William Goetzmann and Stephen Schaefer, who advised the Norwegian government to strategically allocate to factors. The three professors were asked to investigate the reasons for the disappointing performance of Norwegian’s sovereign wealth fund in 2008. This fund invests Norway’s oil revenues and is one of the largest in the world.”

“It turned out that the fund’s performance could largely be explained by its exposure to a small group of factors, something that its managers were not aware of at the time. Many of the different asset classes it held had the same exposure so the portfolio was not well diversified at all. The idea of factor investing gained ground among professional investors around the world who faced similar diversification issues and were open to new approaches.”

Robeco embraced factor investing at an early stage, he says. ”But we were also skeptical after Ang, Goetzmann and Schaefer published their report. We looked at many other academic studies on the subject, and tried to fill in the gaps with our own empirical research.”

In the end this research paid off. Robeco is one of the few asset managers that can offer an extensive product range of low-volatility, momentum and value equity strategies. “We didn’t just talk about factor investing, we also developed equity strategies aimed at efficiently harvesting the most important factor premiums,” says Huij.

A different approach

Huij emphasizes how the Robeco approach to developing factor strategies is different from those of others. “Whereas many providers heavily rely on mere statistical patterns in the data, we try to gain insights on where the return and risk is coming from. One of our key findings was that factor premiums are not a compensation for risk. This implies that investors do not need to take extra risks to enhance returns.”

“Take for example the value premium, the extra returns to be gained when investing in value stocks. The existence of this premium is typically attributed to distress risk, i.e. bankruptcy risk. Robeco research found that although a simple value strategy can indeed involve large exposures to distressed firms, the value premium is not necessarily related to this risk. Therefore, investors are better off using an investment strategy that captures the value premium in a way which avoids this kind of extra risk.“

‘Factor premiums are not a compensation for risk’

Blitz agrees that Robeco’s approach to selecting stocks is different. “We integrate several factors in our stock-selection model because we do not want to invest against other proven factor premiums. Incorporating other factors enables us to enhance the risk-return profile of the portfolio. It is not efficient to have positive exposure to valuation, but negative exposure to momentum and volatility. For example, by buying a high risk stock that looks cheap after steep price declines.”

Another dimension in stimulating innovation is educating clients, adds Blitz. “Our clients may face career risk by adopting our innovative factor strategies and so we learn from each other. We regularly discuss our approach and research with our clients, and how we can best tailor our solutions to meet their needs.“

Rising popularity of factor investing

The popularity of factor investing hasn’t gone unnoticed by the competition; many new suppliers have started offering a range of factor investing propositions. Blitz is not fearful of new competition, but says that the growing interest carries risks for investors. “Investors should be aware,” he says. “Many of these strategies are launched without proper investigation of the best approach. If factor investing is not implemented efficiently, investors may miss out on a large part of the potential added value and be disappointed.”

Therefore a rigorous assessment of factor strategies is necessary, says Blitz. We take a prudent approach when assessing new strategies, he says. “Robeco has used data on a large universe of stocks over long periods of time, for many decades. Our research looks at different time periods, countries and even different asset classes. This makes it unlikely that factor premiums are merely a manifestation of data mining. Furthermore, it is not just about analyzing statistical patterns in the data, it also involves thorough academic research to establish why these patterns exist in the first place.”

Innovation and risk reduction can go hand in hand

Innovation doesn’t mean adding more risk, says Blitz. “In fact, risk can be reduced. The riskiness of an innovation depends on the strategy. Our low-volatility strategies are the best example of how we combine a new approach with a prudent one, because these can reduce overall portfolio risk.”

We also put considerable effort into examining how factors can be combined and what is the best way to rebalance the portfolio, adds Blitz. “This is because a single factor can have periods of underperformance. We recommend implementing a diversified approach by choosing more than one factor.”

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