Special Report Factor Investing: Meeting expectations
It is important to have realistic expectations about what factor investment can deliver. Its supporters make a strong case for its advantages but even they concede it is far from a panacea.
Perhaps it is best to start with what it cannot do. Factor investing makes no difference to the performance of the market as a whole. In a hypothetical world where everyone pursued factor-investing strategies, the aggregate returns would be the same as they would have been otherwise. This is arguably different from, for example, activist investing where its proponents sometimes argue it can help companies perform more efficiently.
Of course, the alternative purely factor-investing world is a long way from what exists today and is arguably likely to remain so. Factor investing is still a minority pursuit. But it is worth remembering that factor investing is essentially about gaining an advantage relative to other market players. In crude terms, it is like hiring a maths geek as a way of getting an edge over other investors.
The tricky question is how large that edge is likely to be. According to Professor Noël Amenc, a professor of finance at EDHEC Business School in Nice, the academic literature suggests that improved performance of 2-3% a year on average is feasible. That may not sound like a lot to some but compounded over several years it would make a considerable difference.
Factor investing can also help with diversification. So even if the level of return is not increased, the level of risk can be reduced. That means that risk-adjusted returns can be enhanced even in a situation where unadjusted returns are static.
This survey will examine the burgeoning area of factor investing – also known as smart beta – from a variety of perspectives.
In broad terms, the first few articles look at some of the more fundamental questions related to factor investing. These include a look at why factor investing works, the challenge of factor timing and how the field relates to developments in big data.
Another set of articles deal with more directly practical questions. The more general ones look at how to combine factors and dealing with factor crowding. Then there are considerations of particular asset classes including emerging markets, currencies and corporate bonds.
Finally, there is the question of how pension funds are using factor investing. This is covered by a case study of the UK’s Local Pensions Partnership and another one of France’s Fonds de Réserve pour les Retraites or FRR (a publically-owned and state funded agency).
With factor investing growing rapidly it is more important than ever to understand it. We hope this survey is a contribution to that task. If you have any comments please let me know.
Daniel Ben-Ami, Deputy Editor, IPE