Investment Options: Deciding factors
Investors looking to enter the world of factor investing are faced with an array of products from simpler beta strategies to actively managed quant funds, finds Charlotte Moore
At a glance
• Factor-investing products span a broad universe from straightforward smart beta solutions to more expensive actively managed quant funds.
• Pension funds with greater governance capacity can implement simpler strategies and manage them in-house, while smaller schemes need to outsource product monitoring and adjustments.
• Factor-investing strategies are becoming more sophisticated and cheaper, giving schemes much greater choice.
• Segregated accounts and pooled funds are the preferred way for pension schemes to access these investment strategies.
Not only can it sometimes be tricky to grasp the somewhat fluid concepts of factor investing, implementing the strategy is also far from straightforward.
Allocating assets to these strategies is a complex process which requires several decisions. These include deciding whether the scheme wants a quasi-passive or more active implementation, how many factors it wants to access and across which asset classes.
In addition, decisions need to be made about how factor investing fits with other existing investment styles in the portfolio.
Investment-factor product universe
A helpful way to think of factor investing is to view it as a quantitative way to access specific risk premia. There is a range of different approaches which vary in how actively the strategy is managed.
At the cheapest end of continuum are products akin to passive vehicles – they are often indices tilted towards one particular investment factor and known as smart beta products. They employ a simple and transparent rules-based approach.
David Gibbon, head of EMEA investment strategy at BlackRock’s factor strategies group, says: “These strategies are not especially dynamic and will rebalance with the same frequency as a broad market index.”
The fees charged for these simple products are akin to those charged for market-capitalisation-weighted indices. Ana Harris, portfolio strategist at SSGA, says: “There are now some ETFs [exchange-traded funds] charging only nine or 10 basis points.”
At the other end are actively managed quant strategies, which typically exploit a range of different investment factors across a number of asset classes. They may also use a long/short approach to remain market neutral, which has been outlined in academic research as the best way to exploit these strategies. Allocation to the different factors will also be managed dynamically and at the discretion of the manager.
These products are more expensive. Phil Tindall, director of investment at Willis Towers Watson, says: “Typically the difference in management fees between the rules-based approach and the active quant approach is around 30 basis points.” But the cost of these strategies can be much higher – they can be higher than 0.75%.
Lying between these two extremes of quasi-passive and active strategies are more sophisticated implementations of investment factors. Tindall says: “These products typically use multiple factors, often with some elements of active quant.”
Once a pension scheme decides to invest in more than one factor, however, it needs to decide how that asset allocation should be managed. Tindall says: “In the past, the only way to do this was to employ an active quant manager.”
But there are now managers who will use a range of cheap factor indices to access these investment strategies and charge a small fee for discretionary asset allocation. Tindall says: “These cheaper multi-factor strategies have been developed by many active quant firms who recognise that ‘smart beta’ has changed the rules of game.”
These middle-of-the-road products have lower management fees because they are using cheap indices as a way to access investment factors as well as providing a less dynamic asset allocation strategy. These products will often be exploiting different factors across multiple asset classes.
NN Investment Partners has recently launched such a product. Willem van Dommelen, head of multi-asset systematic strategies at NN Investment Partners, says: “Our fund uses a number of different investment factors across a range of different asset classes using a market-neutral approach.”
Unlike more expensive actively managed quant strategies, however, this fund will be lower cost because it is implementing its asset allocation using cheap products such as futures and indices. In addition, the fund has a competitive total-expense ratio.
Brian Wimmer, senior investment strategist at Vanguard, says: “The principal variable which changes along the product continuum is the discretion and the skill of the active manager.”
These skills will vary from product to product. Wimmer says: “It could be the manager is using a more complex definition of the factor. Or that the manager moves between different definitions of the factor depending its relevance at a particular time.”
Harris adds: “The tool kit available to the manager increases along the continuum.” This increases the ability of fund manager to react to specific market trends and take more tactical decisions.
Before allocating to any investment factor a pension scheme may want to review its overall portfolio and analyse where it already has exposure to particular investment factors.
Tindall says: “There is little point, for example, in adding a value-factor index if the scheme already has a good active-value manager.” Instead, it would make sense to add an index tilted to momentum, as these two strategies tend to be negatively correlated.
Gibbon agrees: “Typically we will work with pension schemes to assess the factor exposures provided by the active managers and offer ways to access those which are missing.” Access to these missing factors can be provided using a ‘smart beta’ product in the form of an index tilted towards the relevant investment factor, he adds.
While this sounds like a profoundly sensible approach, it is far from straightforward. Tindall says: “This is a sophisticated approach as it requires an in-depth of analysis of which factors a pension scheme already has included in its portfolio. That can be a lot of work.”
As this level of in-depth analysis is time-consuming, pension schemes may, instead, decide to just have a combined factor exposure, adds Tindall.
Gibbon agrees: “For many smaller schemes, it can make sense simply to target multiple investment factors using a long-only implementation strategy.”
Deciding which type of investment factor product suits a particular pension scheme best is determined by how much governance effort a scheme can apply to this asset allocation strategy: the simpler the product, the greater the pension scheme governance burden.
An index provider has a clear mandate. François Millet, head of product line management for ETFs and indexing at Lyxor Asset Management, says: “The factor-index product provider is only responsible for providing an accurate replication and minimising the tracking error of that strategy.”
Harris adds: “An index will simply carry out what it has been built to do – harvest that particular factor. It will not react to the market environment.”
The responsibility for ensuring that a particular investment factor is the right strategy falls entirely on the shoulders of the pension scheme. “It is not the responsibility of the asset manager to explain why this strategy is, for example, underperforming the market,” says Millet.
Wimmer agrees: “Using a transparent process implies the end investor wants to have more control over the factor exposure in the portfolio.”
This governance burden means it is often the larger institutions which opt for the simpler products. Wimmer says: “These institutions want a product to fill a specific factor-investment hole in their portfolio and have the governance to monitor this asset allocation.”
Giving the manager more control over how the factor exposure is managed, outsources this control over the factor exposure. Wimmer says: “These products will be less transparent than the simpler product.”
It is often smaller institutions which select these products, as they do not have the resources to carry out the necessary analysis of their portfolio to determine which investment factors they lack. They might also not have the necessary governance to monitor and adjust a specific factor.
Evolution of factor investing
Most European pension schemes first dipped their toe in the water of factor investing with an equity product. Van Dommelen says: “Typically, pension schemes have replaced their equity manager with a single-factor fund.”
As schemes become more familiar with factor investing, however, they are employing more sophisticated strategies. Tindall says: “There is a trend towards using multiple investment factors.”
Once schemes are comfortable with using a single-factor index, they become aware that different factors perform better at different points of economic and financial market cycles. Gibbon says: “Each factor has its own cycle, which means there will be periods when it underperforms.” These periods can be long.
Alexei Jourovski, Unigestion’s head of equities, says: “Pension schemes should understand that in particular market conditions, specific investment factors are likely to underperform.” For example, in 2009 the value of momentum stocks plummeted as the equity market digested the impact of the global financial crisis.
Tindall says: “To make the most of a particular investment strategy, it makes sense to exploit a number of different returns.” The diversification across a range of different factors will smooth out the return profile, he adds.
But investing in several different factors raises a question about how this asset allocation should be governed. Tindall says: “Schemes will need to decide if they have sufficient resource to manage this asset allocation internally, or if it should be outsourced.”
Processes within single-factor products are also becoming more sophisticated. Simple rule-based approaches can lack finesse. For example, if an index only uses a price-to-book ratio to screen for value companies it will select strong but undervalued companies, as well as weak stocks trading at a fair valuation.
Active managers can better avoid these ‘value traps’ as they can apply their own expertise and skill to identify these stocks and remove them from the portfolio. But index providers are now refining their algorithms to capture and exclude these bad apples. Millet says: “For example, analysing the direction of forecast earnings per share helps to eliminate these value traps.”
Implementing factor investing
While the number of ways to access factor investing has exploded in recent years, including a rapid proliferation in exchange-traded funds (ETFs), most pension schemes tend to stick to tried and tested routes of implementation.
“Most pension schemes will implement this strategy using either a segregated account or pooled fund,” Tindall says.
ETFs tend not to be used by pension schemes. While ETFs have the benefit of intra-day price transparency, this is a more useful characteristic for tactical traders. Gibbon says: “Most pension funds do not want to implement these strategies in this way, so they use other factor strategies to meet their long-term goals.”
ETFs have traditionally had higher total costs than large institutional pooled funds. However, competition is bringing ETF costs down, adds Tindall.
Deciding whether to use a segregated account or a pooled fund is usually a function of the size of the pension scheme. Tindall says: “Larger schemes tend to use segregated accounts, while smaller schemes use pooled accounts.” Harris adds: “An off-the-shelf pooled product might not fit all the requirements of a pension scheme.”
Segregated accounts make this a more bespoke investment. Tindall says: “Schemes can, for example, use their voting rights in a particular direction for particular stocks and allow them to shape the portfolio according to ESG [environmental, social and governance] considerations.”
Despite the benefits of segregated accounts, most pension schemes access these strategies using pooled funds. That is partly driven by supply. John Breedon, head of investment consulting at UK-based JLT Employee Benefits, says: “There has been a rapid increase in the number of pooled vehicles offering factor-investment strategies at a reasonable cost.”
Pooled funds also suit many pension schemes as it reduces their governance burden and allows them to benefit from economies of scale, adds Tindall.