Factor Investing: Navigating the factor maze
I remember when I first heard the term ‘factor investing’ a couple of years ago I was puzzled. I had been writing about funds for many years but I had not come across it. Although the subject seemed new in some respects, in other ways it was strangely familiar.
I had a similar reaction two or three years earlier when I first came across ‘smart beta’. It felt like I had heard about it before, yet the terminology had moved on from its earlier incarnation.
It is only recently that I have come to realise that factor investing – also known as smart beta, alternative beta, strategic beta and by several other names – has a paradoxical old-new character. Many of the concepts are relatively old but they have been repackaged and new twists added.
For example, by the 1990s it was already common in asset management circles to talk about style investing. The focus then was largely on growth (essentially equities that offered the prospects of strong earnings growth) and value (stocks that were relatively cheap according to some metric such as the price-earnings ratio). Even back then, there were variations such as GARP (growth at a reasonable price) that tried to combine the best elements of both approaches.
Indeed, even smaller-company investing can be seen as an early form of factor investing. As far back as the 1980s it was widely argued that smaller companies tended to outperform larger ones over time.
One important shift in recent years is that the number and sophistication of factors has increased enormously. By some counts, there are several hundred factors which investors can harness. That has given rise to what John Cochrane, in his 2010 presidential address to the American Finance Association, dubbed the factor “zoo”.
Another key innovation is the linking of factor investing to behavioural traits. For example, many investors might avoid low-volatility stocks because they seem less exciting than their racier peers. Such behavioural biases in themselves create opportunities that canny investors – or those with a maths PhD to help them – can capitalise on.
In relation to low-volatility stocks, it can create the paradoxical situation where lower-risk stocks outperform higher-risk ones. A central premise of investing – that it should be necessary to take higher risks to gain higher rewards – seems not to apply.
Our latest report on factor investing is a guide to the maze that the sector has become.
At its core is a consideration of what pension funds can expect to achieve. At the start, I warn that the price of higher returns over the long term could be short or even medium underperformance. Factors can sometimes go out of favour for significant periods. Carlo Svaluto Moreolo examines how investors can use the approach to take better control of their portfolios while we also quiz pension funds about their perspective.
Another important consideration is the underlying thinking. We talk to pioneers in the field, while three academics from Cass Business School in London outline the concept’s history.
From a more practical perspective, there are articles on the range of providers, and a guide to the factors.
Meanwhile, we examine why French practitioners are so prominent in the field. There seems to be something about the French educational system that encourages an interest in mathematical finance.
If you have any questions or comments on the report please contact me on firstname.lastname@example.org.
Daniel Ben-Ami, deputy editor, IPE