Understanding factor investing
Interest in factor investing – sometimes known as smart beta investing – is increasing. According to Morningstar data, over 60 smart beta-related ETFs were launched in 2015 in Europe, which was almost double the number launched in 2014 and a significant jump from eight in 2013. Strong demand reflects the different ways in which investors want to focus their portfolios on a particular investment theme – or factor – to enhance returns, manage risk or complement other strategies in their portfolios. But what are factors and what can institutional investors expect from factor-based portfolios?
Despite the recent surge, factors have been around for over 50 years. Factors and the premiums associated with them were first established by academic research in the early 1960s. Work on the capital asset pricing model (CAPM) proposed that an investment’s return was a function of the investment’s sensitivity to market risk. Investments with a high exposure to this market risk – or high beta – should, in theory, earn higher returns. CAPM is a single-factor model whereby the market is the only factor considered.
The research evolved with arbitrage pricing theory, which allowed for multiple sources of systematic risk. Empirical evidence, however, found that returns were related to a stock’s characteristics. These relationships were described as anomalies as they are inconsistent with CAPM theory. One of the first so-called anomalies identified was the size effect, in which portfolios of small-cap stocks experienced higher risk-adjusted returns than portfolios of large-cap stocks. Further research identified the value anomaly and then other factors associated with premiums, as described in figures 1 and 2. Factors are not unique to equities, but are also found in bond markets, with term and credit the most common.
Factors explain the drivers of an investment’s risk and return. For example, the return for a market-capitalisation index fund that closely tracks its index is the market factor, or beta. Investment returns for other strategies are likely to be a combination of the market and any investment styles favoured by the portfolio manager such as value, growth or small-cap stocks. There maybe even some alpha due to the portfolio manager’s security selection or market timing skill.
From theory to reality
Factor-based investing developed from this research. It has many labels, including smart beta, enhanced indexing and alternatively weighted strategies to name a few. But the common characteristics of these strategies are that they are rules-based and that they aim to capture systematically the premiums associated with one or more factor.
There are also many ways to do this. Institutional investors need to be confident that the methodology chosen will reflect their desired factor exposure. While factors can be relatively easy to describe, measuring them is not always straightforward. For example, what metrics determine a value stock? Is it price to book, price to earnings, cash flows, dividends or a combination?
Another consideration is the portfolio construction process. With a passive approach that tracks a factor index there is the potential for inconsistent factor exposure. After all, markets and stock prices are constantly changing. Depending on how frequently the index and portfolio rebalance, investors could find their factor exposure drifts as markets move.
Other implementation methods are more active in approach, using quantitative models to target the desired factor. These models are generally dynamic as they do not rely on periodic rebalancing. This allows them to respond to changing prices and opportunities in the market. And it means that the portfolio can maintain its factor exposure even as markets shift.
Taking on active risk
The key point to make is that regardless of implementation method, a factor portfolio is likely to deviate considerably from a broadly diversified portfolio based on market-cap weights. The consensus expectations of market participants determine market-cap weights. When other criteria are used to weight securities, investors are making an active decision and taking on active risk.
This means factor portfolios could diverge significantly from the broad index in terms of industry or country weights. For example, a low volatility portfolio could find its holdings concentrated in defensive industries, such as food manufacturers or pharmaceuticals. Some sophisticated models can control for unintended risk exposures with acceptable ranges or limits on regions, countries, sectors and liquidity.
As you would expect with active risk, investment returns are likely to be cyclical. Factors will outperform and underperform the market at different times, as figure 3 demonstrates. It shows that different factors have led the market at different times. This lack of persistence for any particular factor demonstrates that factor investing, like all investing, requires a long-term perspective.
Benefits of factor investing
While periods of underperformance can be expected, an explicit focus on factors offers potential benefits in terms of transparency, cost and control. By deliberately focusing on factor exposures in portfolio construction, investors may gain a clearer understanding of the drivers of portfolio returns. In some cases, investors may be paying high fees to obtain factor exposures that are available more cost-effectively by allocating explicitly to a factor.
As already mentioned, some fundamentally weighted – or smart beta – indices provide factor exposure that could vary over time. While this may be appropriate for some investors, others may want more direct control over their portfolio’s factor exposures. The decision to delegate factor exposures to a manager or an index, or to maintain direct control over factor exposures, is an important one for those considering factor-based investing.
Risk or opportunity?
The increase in factor ETFs provides institutional investors with new tools to implement their investment strategies. Factor funds can help investors target a particular source of return, or manage risk levels. However, some caution is required. The ETF’s methodology and portfolio construction process must be scrutinised to ensure it delivers consistent exposure to the factor.
Investors need to understand that factor investing won’t be a smooth journey. They need to be confident that the risks and returns from their choice of factor will help them meet their long-term investment objectives.
Brian Wimmer, senior investment strategist, Vanguard Group