Factor-based allocation has become increasingly popular in recent years. But how to implement it in practice still remains a puzzle for many investors. Two pitfalls which must be avoided are unintended sector biases and excessive concentration on a particular sector.
Factor-based investing has gained considerable traction over the past decade. Concepts such as ‘factor premiums’ or ‘smart beta’ have become popular buzzwords, and now appear frequently in mainstream financial media. Prominent institutional investors have also publicly embraced allocation to well-documented factors. But despite growing awareness as to the potential benefits, many still struggle with how to put such strategies into practice in their portfolios.
In the previous article in this series, which is dedicated to the major challenges investors face in factor investing, we advocated a comprehensive and balanced approach in terms of exposure to different premiums. Because factors can clash with each other and are virtually impossible to time effectively, investors must avoid any excessive or undesired exposure to individual premiums.
The same is true for geographic regions, countries and business sectors, as well as individual stock exposures. Portfolio construction processes that focus solely on factor premiums can lead to significant, unintended biases, especially in terms of sectors. In a recent whitepaper (1), researchers from the Scientific Beta/EDHEC-Risk Institute showed that portfolios targeting greater factor exposure also tend to focus heavily on a limited number of industries, and concentrate on fewer sectors overall.
For example, a strategy designed to capture the momentum premium without taking into consideration any other element, may rapidly lead to excessive concentration of the portfolio on a small number of industries that may be in vogue at the time. As a result, sector-specific developments can significantly undermine overall performance.
Concentration risk is especially important for generic factor-based strategies, particularly when they rely on the replication of popular smart beta indices (2). Many of these products do not have explicit concentration limits. The S&P 500 Low-volatility index is a good example. There are no constraints on sector weights, which can lead to huge concentrations. As a result, in December 2012, around 60% of this index was invested in only two sectors: utilities and consumer staples.
Investors take this issue very seriously. In fact, a FTSE Russell survey carried out in 2016 suggested that avoiding unintended sector biases ranked third among investor concerns regarding factor allocation.
Efficient factor strategies must integrate strict but workable concentration rules
Although the focus should remain on optimizing exposure to relevant factors, the merits of broad diversification across a varied selection of securities should not be forgotten. Robeco’s in-house research shows that adding constraints on sector weights to an unconstrained portfolio reduces concentration risk while not significantly altering returns, at least to a degree. At a certain point, however, concentration limits start to have a negative effect on performance.
As a result, there is a converse relationship between the return/risk ratio of a portfolio and concentration levels, as measured by the allowed active weight for regions, countries, sectors, size groups or single stocks. This means that an optimal level of concentration exists that must be taken into account by investors.
Efficient factor strategies should therefore not only focus on maximizing exposure to premiums, but should also prevent unintended geographic or sector biases, as well as undue concentration on some single stocks or sub-segments of the financial markets.
To ensure appropriate diversification, all of our quantitative strategies are subject to strict but workable concentration rules, that lead to a varied selection of stocks or bonds while avoiding excessive sector and country tilts.
For our Factor Investing Solutions and our Conservative Equities portfolios, for example, we apply position limits that allow an absolute deviation from the MSCI Index weight for regions, countries and sectors that does not exceed 10%. For size groups (large, mid and small caps), the maximum allowable deviation is 20%. Meanwhile, the maximum percentage that can be invested in a single stock is 2%.
ll these concentration limits are based on thorough research. They are monitored by the portfolio management team as well as Robeco’s Compliance department. They are intended to further reduce concentration risk while maintaining focus on the primary objective: achieving the best possible exposure to the targeted factor premiums.
Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.
The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. 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.
In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.
In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.
Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.
If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.