The growth has only just begun
Lynn Strongin Dodds sees signs pointing to a continuing rise in factor-based investing
At a glance
• The industry is at the nascent stages of growth but assets under management are increasing.
• Smart beta or factor based products will gain traction because they are a more cost effective way to gain diversification and higher risk adjusted returns.
• The rise of factor investing is part of a more general trend towards passive investing as investors are disgruntled with high fees and poor performance from active managers.
• Standalone fixed-income products are also coming, albeit slowly, onto the market as well as equity funds that use hedge fund strategies such as long/short.
Although it seems like the market is inundated with factor-based, alternative indexation or smart-beta strategies, the industry is still in its nascent phase. Assets under management are expected to continue their upward trajectory while strategies move from equities to fixed income and all-encompassing multi-asset funds, as investors explore different avenues for higher returns and lower fees.
“I still think we are in the early stages,” says Yaz Romahi, CIO, quantitative beta strategies at JP Morgan Asset Management. “There has been a lot of debate but the volume of assets is still quite small and it is mainly the larger and more sophisticated institutions who are investing in factor-based strategies. However, I do think there will be significant growth in the future because they create a much more efficient, less correlated and diversified portfolio than traditional market cap investing.”
There are also several tailwinds that will continue to drive the trend. For a start, factor investing is widely seen as based on the most sophisticated academic research in the area. In addition, investors are looking for ways to enhance returns or mitigate volatility at a time when lower returns are expected overall in both fixed income and equities. “Also there is significant pressure on the buyside to reduce costs and an increasing scepticism about active managers’ ability to generate alpha,” says Daniel Reyes, principal, advised portfolio solutions, at Vanguard. Factors can be seen as a viable substitute for high-cost active.”
The shift also reflects the general trend to passive products. This was highlighted last year with European passive funds – both index funds and exchange-traded funds (ETFs) – garnering $83bn (€78bn), outstripping the $48bn netted by their active peers, according to research from Morningstar. Overall, roughly $6trn has poured into traditional passive funds last year.
This may eclipse the money streaming into smart-beta products but it is a growing segment of the market with global inflows hitting the $559bn mark by the end of 2016, while the ETF versions reaped over €52bn. Many analysts predict that this figure could climb to $1.6trn in three years’ time.
Looking at Europe specifically, industry participants expect retail investors’ interest to be further piqued by MiFID II (Markets in Financial Instruments Directive) which comes into force in 2018. This could push European smart beta assets to €230bn levels, with at
least €150bn being slotted into ETFs by 2020. This is up from the €43bn last year and a quadrupling in AUM since 2012, according to Morningstar.
Not surprisingly, as the latest FTSE Russell survey, which canvassed 250 asset owners, reveals, the larger and more sophisticated asset managers with roughly $10bn in their coffers are the most enthusiastic. About half of these managers have a smart beta allocation, although the number of their smaller brethren in the $1bn to $10bn AUM range currently evaluating this route has doubled since 2014.
There is no doubt that newcomers and existing firms will continue to be spoilt for choice as the number of products continue to mushroom. However, one healthy development is that many providers have become more thoughtful in the development of their offerings. “A few years ago, the market seem flooded with literally thousands of supposedly smart beta ideas with some market participants even suggesting that hundreds of factors existed,” says, Jonathan White, deputy head of client portfolio management at AXA Investment Managers. “This noise made it complex for asset owners to assess their options. Today, a positive aspect is that practitioners and asset owners seem to be coalescing around a small handful of factors.
Take equities, as this is the area where the approach is most advanced. Today the factors are limited to the ‘famous five’ – value, momentum, size, quality and low volatility. “This reduction of noise is helpful when working with asset owners on investment options,” White adds.
There is also recognition that these five can be applied to other asset classes as standalone products or bundled together in one fund. “Investors initially started with equities because they are liquid markets and easy to implement,” says Javier Rodriguez Alarcon, head of quantitative investment strategies at Goldman Sachs Asset Management. “However, now what we are seeing and will continue to see is a move towards a wider universe that encompasses multi-factor portfolios from other asset classes – for example, fixed income, currency as well as commodities – because there is a greater understanding of the risk and return drivers. At one time, this was exclusively the domain of alternative managers. But now alternative risk premia and smart beta solutions offer the tools necessary for clients to have access to these exposures in a more cost-efficient way.”
Stan Verhoeven, lead portfolio manager, for multi-asset factor opportunities at NN Investment Partners, also says that multi-factor strategies will continue to gain traction in the future. He expects factors to continue to have positive expected returns because the drivers are not likely to evaporate. This is a result of: investors’ perennial desire to be compensated for taking a risk; human behaviour generally does not change and investors’ objectives; and restrictions will continue to generate supply and demand imbalances.
The benefits are the lower correlations between the asset classes but the challenges are getting the right blend. “For example, equities and high-yield are highly correlated but if you add commodities to the mix, oil and wheat are heterogeneous and do not have the same dynamics, which makes the case for multi-asset factor investing as asset class dynamics differ” he adds. “Furthermore, it is important to have a robust investment process that identifies and applies true factors that are supported by a strong economic rationale and can deliver positive expected returns after transaction costs in the long run.
Bernhard Langer, co-chair of the factor investing council and CIO of quantitative strategies at Invesco, also says that its research has found that investors’ focus is less on off-the-shelf factor products and more on strategic factor models and a holistic multi-factor approach which explains all of their factor exposures,
There are, though, regional differences. He notes that, for example, while sovereign investors in Asia have been the fastest adopters of internal risk-factor models, German insurers, driven by liquidity requirements and regulatory constraints, are migrating from fundamental investments to smart-beta ETFs and equity-factor models to improve risk-adjusted returns. “In the UK, post retail distribution review, charge caps on default funds and stakeholder engagement have facilitated growth in smart-beta products, so that UK defined-contribution pension funds are now using factor products because they offer a cheaper route to diversification,” Langer adds.
There has also been innovation within the single-factor strategies, particularly in equities with long/short hedge-fund frameworks that use derivatives and leverage, as well as standalone fixed-income products, although they have not yet caught on in the same way. Currently, for example, there are fewer than 30 of the more than 800 smart beta ETFs listed on ETF.com’s industry database cover bonds.
“We are seeing growth in fixed income for the same reasons as in equities because they have well-known premia that can be captured,” says Gerard Fitzpatrick, CIO of EMEA at Russell Investments. “The potential factor exposures are credit, illiquidity and term, but it is important to manage them dynamically to capture the cyclicality as well as mitigate or avoid short-term losses. The downside is that these are not as tested as traditional fixed-income asset classes and they require careful thought when building a portfolio.”