True factor investing involves short as well as long positions, yet, as Charlotte Moore finds out, the costs of shorting erodes much of the benefits
While most factor indices are long-only products, a market-neutral approach should be a much more effective approach to these strategies. After all, if an investor chooses an alternative index in a bid to get exposure to, for example, the value factor, it makes sense purely to access that return driver rather than getting something with general equity-market risk mixed in.
The genesis of factor investing lies in the pages of financial journals, where academics published their discoveries regarding the low-volatility anomaly, as well as proving that value stocks provide some the best long-term performance. Those research ideas sowed the seeds for today’s alternative indices.
There is always a difference, however, between the purity of an academic investment thesis and the compromised reality of the solution which evolves from that idea. Dan Mikulskis, co-head of ALM & investment strategy at Redington, says: “Academics defined these factors using a long/short approach rather than long-only.”
For example, those academics defined value by dividing book-to-price ratios into quintiles. “The research looked at the impact of going long the top-value quintile and shorting the bottom quintile,” says Mikulskis. The literature demonstrated that factor strategies have the best performance when they are implemented using a long/short approach, he adds.
Joop Huij, head of factor investing research at Robeco, says: “The theoretical Sharpe ratio of the long/short strategy is significantly larger than with long-only strategies.” In some cases, it can be twice as large, he adds.
By using a long-only fund or index, investors limit themselves to only one option – they can only buy the cheap value stocks and not go short the expensive stocks. “That means investors are effectively missing out on half of the available alpha from this strategy,” says Mikulskis.
Market dynamics should provide further support for the long-term efficacy of this approach. Almost all alternative index products are long-only, making this a very crowded trade. “In contrast, there are relatively few long/short strategies which should make this investment strategy more durable,” says Mikulskis.
Long/short strategies are also a less risky investment strategy. For most stocks, the market risk is the most dominant factor. By using a long-only approach, investors are getting a very high exposure to equity market risk and much less exposure to the factor-risk premium, says Mikulskis.
“We found that a large amount of the added advantage of short selling disappears when transaction costs are included”
With such indisputable evidence for the benefits of employing a long/short strategy, it seems odd that more investors have not opted for this investment approach.
But that’s because there is a difference between the clear logic of an academic idea and the messy reality of constructing an investment product. Huij says: “There is a significant gap in the academic literature – it has ignored market frictions and does not take market trading costs into account.”
While a long-only strategy is a cheap and easy to implement – most equities have good liquidity and transaction costs tend to be low – the costs of shorting are higher, as they involve borrowing securities. Running a short position for long periods of time can have a prohibitively high transaction cost which could effectively erode any potential returns.
It is also cheaper to short some stocks compared with others. While large-cap stocks can be shorted at a reasonable cost, this is not the case for smaller stocks.
Not only are short positions more expensive, but there is no standard cost – it varies from manager to manager. Huij says: “Some fund managers have better operational skills than others and are therefore able to keep costs under control.”
Raul Leote de Carvalho, deputy head of financial engineering at BNP Paribas Investment Partners (BNPIP), adds: “It is not that easy to implement a long/short alternative index strategy because the problems that need to be overcome are not trivial.”
To correct for the oversight in the academic literature, Robeco ran its own analysis, taking the cost of implementing short positions into account. “We found that a large amount of the added advantage of short selling disappears when transaction costs are included,” says Huij. In many cases, the value created by including short selling became negative.
Robeco also factored in the different costs for large and small-cap stocks. “That made the value added by short selling even more negative,” says Huij.
There are, however, ways to get around the problems with implementing a short strategy and still capturing some of the benefits. That can be done by simply going short on the underlying index future. Huij says: “This results in a better risk-adjusted return than the long-only strategy.”
BNPIP found a different solution. For example, for a value factor, a manager can exploit the correlation between overvalued stocks. De Carvalho says: “It’s possible to get similar benefits to a long/short strategy by simply underweighting more expensive stocks.”
While it might be possible to capture the benefits of going short without having to short individual stocks, both of these solutions are pretty complex investment strategies – and that is not what most investors are looking for in their alternative indices.
John Belgrove, senior partner at Aon Hewitt, says: “Investors like these products because they are transparent, simple and low cost, which is not how investors typically consider long/short strategies.”
That does not mean there is not merit in a long/short approach. Belgrove says: “Long/short funds are typically less risky than long-only and can provide a good additional source of return to investors.”
But there are many ways of implementing a long/short approach other than via an alternative index. A pension scheme could choose a more fundamental approach and allocate to a traditional active hedge fund.
More complex investments require more resource to monitor. Belgrove says: “Investors have to be aware that more complex strategies come with higher governance costs.”
Phil Tindall, senior investment consultant, agrees: “Long/short strategies have a higher implementation hurdle. And some pension schemes might not have the governance resource to implement these strategies.”
From the perspective of a purist, using a long-only alternative-index strategy may seem an inefficient investment strategy but not everyone sees it that way. “By using an alternative long-only index, investors are using capital efficiently by getting access both to equity markets and to a particular factor,” says Tindall.
If a pension scheme did decide to use a long/short approach to access a particular investment factor but also wanted exposure to the equity markets, they would then have to make a separate equity market investment – that increases complexity, he adds.