Factor Investing: Trend convergence
Factor investing has proved to be one of the enduring innovations of asset management in recent years, doubtless assisted by the fact that it rests on a body of academic evidence, including Fama and French in 1993.
One important lesson from early adopters of equity factor approaches is that some factors can underperform, and that this underperformance can persist for considerable amounts of time. The underperformance of the value factor recently is a case in point.
Because of the complexities of combining equity factor strategies, many investors have opted for multi-factor approaches, and one of the livelier debates of late surrounds the wisdom or otherwise of factor timing. Another observation has been that certain factors, such as low volatility, have become ‘crowded’ and will not perform as well in the future.
The gradual tapering of QE raises questions about how some equity factor strategies will perform in a new economic paradigm given that equity markets historically underperform during periods of rising rates. The prospect of economic conditions meaningfully different to those we have experienced over the last decade is leading to research and innovation into new types of strategy, including risk-based weightings.
Investment approaches taking into account environment, social and governance factors are also a major trend for institutional investors and asset managers. Pension funds increasingly recognise ESG as a way to mitigate risk, while asset managers are seeking to meet demand from investors by embedding ESG into their portfolio and risk management systems.
Some pension funds, such as Sweden’s AP2, have sought to integrate ESG into equity factor portfolios. Yet ESG can only be compared to ‘conventional’ equity factors – size, value, quality, low volatility and momentum – on a most simplistic level. This comparison would involve placing the established body of equity factor academic research alongside largely proprietary scoring systems.
Such scoring systems typically rank companies on a range of ESG metrics. This is problematic for many reasons, not least because the body of ESG research is less developed and far less comparable than the body of equity factor research. At best, ESG can be seen as ‘orthogonal’ to other factors, or a ‘multi-factor’ element in itself.
Liam Kennedy, Editor, IPE
What is factor investing?
An investment approach guided by a body of academic research pointing to higher risk-adjusted returns against the market-cap index from equity portfolios with greater weightings towards stocks with certain characteristics. These characteristics are generally agreed to revolve around five factors: low volatility, momentum, quality, size and value.
Often known as ‘smart beta’, implementation of equity factor investing can be through index-based approaches, including ETFs, or through active quantitative strategies. ‘Alternatively weighted’ indices have been in existence for some time.
In fixed income it is known that bond indices are inefficient as they give a greater weighting towards issuers with greater levels of debt outstanding. Some have attempted to apply factor investing approaches to fixed income but there is less academic research in this area.
Beyond equities, another set of broader macro economic factors can also be applied across portfolios. These include the equity (beta) risk factor, duration, credit spread, commodity and currency risk. Applying these factors, including through risk-parity approaches, is a growing discipline. Other alternative risk premia, including merger arbitrage, convertible arbitrage or managed futures, are typically accessed through hedge funds.