Factor-based strategies can help investors reduce management costs. Fourth article of a series on how factors can help investors achieve specific goals.
One of the major trends seen in the financial industry over the past couple of decades has been the massive shift away from traditional active investment strategies and the rise of passive investing. Increased cost awareness on the part of clients and successive waves of product innovation, including the rapid expansion of passive index trackers like exchange-traded funds (ETFs), have played a crucial role, as it has become easier for investors to gain market exposure at much lower costs.
But while passive strategies have undisputable merits, they remain far from ideal. Passively following a market-weighted index may be a simple, transparent and cost-efficient way to achieve a diversified portfolio, but it also means acquiring securities without really caring about what is being bought. In addition, passive strategies inevitably lag the selected market index, once fees and transaction costs are taken into account.
In this context, many investors have turned to more systematic active investment approaches, including factor-based investing, in order to achieve better investment results than they would with purely passive strategies at a lower cost compared to traditional active management. In fact, a recent FTSE Russell survey of asset owners found that cost reduction ranked fourth among the top investment goals that led them to consider factor-based strategies.
As the influential 2009 report1 on the Norwegian oil fund and factor investing showed, most of the added value of the fund’s active management did not reflect true skill. On the contrary, it could be explained by implicit exposures to a number of systematic factors, which could be replicated at lower cost compared to traditional active management.
At the same time, Robeco’s research2 and also our real-life experience with managing active factor strategies show that focusing on the well-established factors is clearly worth the effort, compared to passive strategies. Targeting these factors efficiently can add value, even after taking management fees, taxes, trading costs and investment restrictions into account.
Factor investing is about capturing proven factor premiums in a rules-based fashion, in order to generate superior risk-adjusted returns compared to the broader market. This systematic approach to obtain superior performance is generally achieved at a lower cost than with traditional active management. That is why factor investing is regarded by many investors as a third kind of investment strategy in between passive and active, as illustrated in Figure 1.
Similar to passive investing, factor investing is transparent, rules-based and relatively low cost. But like active investing, it has an active return, as illustrated in the image above. As such, many investors, both institutional and individual, have actually embraced it as a third bucket in their portfolio, to achieve consistent alpha over time at lower costs compared to traditional active strategies.
While keeping costs down should remain a priority, going for seemingly cheap generic factor-based products may not necessarily be the best option. These products are often based on popular smart beta indices, which do not unlock the full potential of factor premiums and expose investors to a number of pitfalls, compared to more sophisticated − but also more expensive − active factor strategies.
For instance, Robeco’s Head of Quantitative Research David Blitz showed in a 2016 research paper3 that the amount of factor exposure provided by popular smart beta strategies varies considerably, as does the degree of focus on a single target factor. Smart beta indices exhibit performance that is in line with the amount of factor exposure provided, but it seems that they do not unlock the full potential offered by factor premiums. Moreover, these generic products usually follow fully transparent indices, which have the same methodology and upcoming ‘trades’ and are therefore prone to arbitrage. The simplicity and transparency of these indices mean that other investors, such as hedge funds, can identify in advance which trades are going to be executed, and can opportunistically take advantage of this, leading to high hidden costs for those investing in products that track these indices.
Recent research4 by Robeco shows strong empirical evidence to support that this arbitrage is, in fact, happening. It suggests that many market participants anticipate upcoming trades in these public factor-based indices, at the expense of those who invest based on these indices, either via ETFs or index funds.
1 A. Ang, W. Goetzmann and S. Schaefer, ‘Evaluation of Active Management of the Norwegian Government Pension Fund – Global’, prepared at the request of the Norwegian Ministry of Finance, 2009.
2 E. Van Gelderen and J. Huij, ‘Academic Knowledge Dissemination in the Mutual Fund Industry: Can Mutual Funds Successfully Adopt Factor Investing Strategies?’, The Journal of Portfolio Management, 2014.
3 D.Blitz, ‘Factor Investing with Smart Beta Indices’, Robeco research paper, 2016.
4 J. Huij and G. Kyosev, ‘Price Response to Factor Index Additions and Deletions’, Robeco research paper, 2016.
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