Factor investing has become increasingly popular over the past decade. However, most of the money inflows seen in recent years have been invested through vehicles based on generic indices, often branded ‘smart beta’. Despite their attractive low cost and transparency characteristics, these products raise serious issues regarding their ability to efficiently harvest factor premiums, in particular concerning overcrowding and arbitrage risk. To address this, Robeco is now introducing its new range of bespoke factor indices, say Joop Huij, Viorel Roscovan and Georgi Kyosev.
These days, many asset owners are familiar with implementing the concept of factor investing in equity markets. As a pioneer in this field, Robeco has actually been offering proprietary, actively-managed factor-based solutions for over two decades. The rise of factor investing has resulted mainly from the tremendous success of exchange traded funds (ETFs) based on popular so-called “smart beta” indices.
But while these generic products do offer exposure to well-rewarded factors in a transparent way and at relatively low cost, they remain far from ideal. “Generic factor indices embed significant flaws,” says Joop Huij, head of factor investing at Robeco. “For those clients with a clear focus on passive strategies, we want to offer a much better alternative.”
Many of these index-based products still involve a significant amount of market index exposure as well as unexpected negative exposures to other factors. Moreover, the use of generic factor indices also often implies inefficient portfolio construction processes, that may lead to unnecessary turnover, high concentration on some countries or business sectors or excessive exposure to large capitalization stocks.
In addition, they are also prone to significant overcrowding and arbitrage. Indeed, strategies based on generic factor indices may be fully transparent, but this transparency comes at a cost to investors, warns Georgi Kyosev from Robeco’s factor investing research team. The simplicity and transparency of these indices mean that other investors can identify in advance which trades are going to be executed, and can opportunistically take advantage of this.
“Many clients are simply not aware of front-running,” says Georgi Kyosev. “When we show them our research, they suddenly realize how harmful it can be for their performance.” In a 2016 paper1, which was co-authored by Joop Huij and focuses on the US stock market, he estimated the cost of transparency for public factor indices to be 16.5 basis points per year for investors.
These indices provide efficient exposure to four well-rewarded factors, while keeping costs low and preventing overcrowding and front-running
To provide a solution that would better align with clients’ interests, Robeco is now launching its own family of bespoke multi-factor indices. These indices are designed to provide efficient exposure to four well-rewarded factors, i.e. value, momentum, low volatility and quality, while keeping costs low and preventing the damaging effects of overcrowding and front-running on performance, by keeping them transparent for the clients only.
“Robeco has long been a thought leader in the field of quantitative investing,” says Joop Huij. “Building on our experience, as well as our close cooperation with clients, we want to keep on bringing innovative solutions to the market.” In that sense, Robeco’s newly launched factor indices are just a different way to offer our proven intellectual property to a broader customer base, in a package that was missing from our previous range. “We actually see these indices as a natural extension of our quant product range,” Joop Huij says.
First, we are launching seven indices targeting different geographic areas – global, global developed, emerging markets, Europe, U.S., Asia-Pacific and Japan – using S&P’s traditional market-cap weighted indices as investment universes. “In principle, these indices are standard, although some customization is also possible, in particular concerning sustainability-related requirements,” says Viorel Roscovan a senior researcher from Robeco’s factor investing team.
Indices will be calculated based on Robeco’s stock ranking and portfolio construction models. These models have been developed in-house and have been both extensively tested in historical simulations and used in real time for numerous years.
In practice, Robeco has set up a separate legal entity, as well as a long term partnership with an established index provider, S&P Dow Jones Indices, that will be in charge of calculating and maintaining our multi-factor indices. Robeco will remain owner of these indices and will supply them directly to clients. S&P Dow Jones Indices will not be able to re-license them.
Once the indices are delivered, professional clients will be able to perform fulfillment themselves, sometimes with the intervention of a third party.
The different indices will be rebalanced on a quarterly basis and continuously monitored to adjust for corporate actions when needed. At Robeco, factor indices-related activities, including research, the development of methodologies and the actual provision of indices, will be performed by a dedicated team.
In addition, a number of measures have been implemented to eliminate the risks associated with the circulation of price sensitive information, as well as potential conflicts of interest. “These measures are particularly important,” says Viorel Roscovan. “We do not want trades necessary to rebalance our indices to be publicly available in advance.”
Beyond the crucial transparency issue, Robeco’s new factor indices also feature significant competitive advantages, compared to their generic equivalents. For example, they use enhanced definitions for each of the four factors they exploit, ensuring they avoid unintended factor exposures and classic factor clashes, in order to maximize the risk-adjusted return potential.
Moreover, our indices apply an efficient index construction algorithm which enables a strong tilt towards stocks with low expected risk, attractive valuation and strong positive momentum, while keeping turnover low. In this way, we avoid the typical factor biases associated with generic smart beta indices. This algorithm also ensures appropriate diversification and prevents unintended geographic or sector biases, as well as undue concentration on some single stocks or sub-segments of the stock markets.
In addition, these bespoke indices explicitly integrate ESG criteria in their construction process by ensuring that the weighted sustainability score of the index is at least as high as that of the related cap-weighted benchmark. If the multi-factor index ever receive below average scores for sustainability, the index construction tool will tilt the index towards stocks that are attractive from a factor point of view and that improve its overall sustainability profile.
Ultimately, the objective of our factor indices is to achieve risk-adjusted returns that are higher than those of both cap-weighed market benchmarks and comparable generic factor indices, over a full market cycle. “Clearly, this kind of product has tremendous potential,” says Joop Huij. “We’re going to keep on working on them so that they meet the needs of an ever larger pool of investors.”
1 ‘Price Response to Factor Index Additions and Deletions’, Joop Huij and Georgi Kyosev, 2016.
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